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Special report No 1 / 2002

ISSN 1684-033X

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Responses to the challenges of globalisation

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European Commission

EUROPEANECONOMY

Directorate-General for Economic and Financial Affairs

2002 Special Report Number 1

© European Communities, 2002

Printed in Belgium

Responses to the challengesof globalisation

A study on the international monetaryand financial system and on financing for development

Working document of the Commission services

Abbreviations and symbols used

Member States

B BelgiumDK DenmarkD GermanyEL GreeceE SpainF FranceIRL IrelandI ItalyL LuxembourgNL The NetherlandsA AustriaP PortugalFIN FinlandS SwedenUK United Kingdom

EU European UnionEU-15 European Community, 15 Member StatesEUR-11 Group of 11 Member States participating in monetary union (B, D, E, F, IRL, I, L, NL, A, P, FIN)Euro area Member States currently participating in monetary union (EUR-11 plus EL)(EUR-12)

Currencies

ECU European currency unitEUR euroATS Austrian schillingBEF Belgian francDEM German mark (Deutschmark)DKK Danish kroneESP Spanish pesetaFIM Finnish markkaFRF French francGBP Pound sterlingGRD Greek drachmaIEP Irish pound (punt)ITL Italian liraLUF Luxembourg francNLG Dutch guilderPTE Portuguese escudoSEK Swedish kronaCAD Canadian dollarCHF Swiss francJPY Japanese yenSUR Russian roubleUSD US dollar

iv

Other abbreviations

bn, billion 1 000 millionCPI Consumer price indexEC European CommissionECB European Central BankECSC European Coal and Steel CommunityEDF European Development FundEIB European Investment BankEMCF European Monetary Cooperation FundEMS European Monetary SystemEMU economic and monetary unionERM exchange rate mechanismEuratom European Atomic Energy CommunityEurostat Statistical Office of the European CommunitiesFDI foreign direct investmentGDP (GNP) gross domestic (national) productGFCF gross fixed capital formationHICP harmonised index of consumer pricesILO International Labour OrganisationIMF International Monetary FundLDCs less developed countriesMio millionMrd 1 000 millionNCI New Community InstrumentOCTs overseas countries and territoriesOECD Organisation for Economic Cooperation and DevelopmentOPEC Organisation of Petroleum Exporting CountriesPPS purchasing power standardSMEs small and medium-sized enterprisesVAT value added tax: not available– none

v

Acknowledgements

The study was produced under the direction of Johan Baras, Head of Unit in the International Matters Directorate,Directorate-General for Financial Affairs.

The lead authors were Ian Vollbracht (Chapter I), Bernard Brunet, Daniel Daco and Reinhard Felke (Chapter II), PierreBaut, Anne Bucher, Francesca Di Mauro and Barbara Kauffmann (Chapter III).

Additional contributions were made by Sean Berrigan, Alina Boiciuc, Louise Curran, Ditte Juul-Jorgensen, KenLennan, Matthias Mors, Françoise Moreau and Malindi Myers.

Comments and suggestions by Joly Dixon, Elena Flores, John Macdonald, Oliver Schmalzriedt and colleagues fromother services of the Commission are gratefully acknowledged.

Secretarial support was provided by Annemie Loots and Lisbeth Vognsen.

Comments would be gratefully received and should be sent to:

Johan BarasEconomic and Financial Affairs DGEuropean CommissionB-1049 [email protected]

Contents

List of abbreviations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Chapter I: Globalisation: where do we stand? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

A. Current globalisation trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

B. Forces driving globalisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

C. The benefits of globalisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

D. Challenges facing the system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Chapter II: The international financial system in a globalised world. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

A. Trends and achievements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

B. Systemic issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

B.1. International monetary stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

B.2. Abuses of the global financial system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

C. Towards a more stable and better functioning international monetary and financial system . . . . . . . 43

C.1. Modalities of crisis prevention and management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43C.1.1. Crisis prevention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44C.1.2. Crisis resolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47C.1.3. Excursion: currency transactions taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

C.2. Reducing the abuses of the financial system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

C.3. Regional and global cooperation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

C.4. Towards improved governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

Chapter III: Promoting and financing development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

A. Assessment of existing instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

A.1. ODA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64A.1.1. Trends in ODA and the 0.7 % target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64A.1.2. Improving effectiveness and the quality of aid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

A.2. Debt reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70A.2.1. Trends and figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70A.2.2. Debt-reduction mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71A.2.3. Continued debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

A.3. Integration into the global trade system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75A.3.1. Trends in trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75A.3.2. The challenges of integration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

1

A.4. Attracting foreign direct investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83A.4.1. Trends and figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83A.4.2. Impact of FDI on developing countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84A.4.3. The challenge of attracting FDI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

B. Alternative financing instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

B.1. International taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88B.1.1. Taxes versus national contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88B.1.2. The framework of international tax proposals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89B.1.3. Provisions and features of the tax proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90B.1.4. Legal basis and compatibility with existing legislation. . . . . . . . . . . . . . . . . . . . . . . . . 95

B.2. Other proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97B.2.1. The de-tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97B.2.2. An SDR allocation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

List of references . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

FIGURES

Figure 1: Trends in world trade in goods (volume) v GDP (1990 = 100). . . . . . . . . . . . . . . . . . . . 18

Figure 2: Correlation between domestic saving and domestic investment, and current account as a % of GDP for 12 major countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Figure 3: Composition of private-capital flows (1973–81, 1990–97). . . . . . . . . . . . . . . . . . . . . . . . 21

Figure 4: Long-term trends in US immigration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Figure 5: Relative transportation and communications costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

Figure 6: Total government outlays relative to GDP (1913, 1960, 2000).. . . . . . . . . . . . . . . . . . . . 23

Figure 7: Life expectancy by country grouping in 1997 and increase on 1970 . . . . . . . . . . . . . . . . 28

Figure 8: GDP growth by country grouping (1960–2000). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Figure 9: Net ODA in 2000 — in % of GNI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

Figure 10: Developing countries’ exports by sector (billion EUR).. . . . . . . . . . . . . . . . . . . . . . . . . . 76

Figure 11: EU trade with developing countries (billion EUR). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

Figure 12: Tariff escalation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

Figure 13: Pattern of protection facing LDC exports (pre-EBA). . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

Figure 14: Distribution of world inward FDI stock (%). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

2

List of abbreviations

ACP African, Caribbean and Pacific countries

ADB Asian Development Bank

ALA Asian and Latin American developing countries

ASEAN Association of South-East Asian Nations

ATW Air Transport World

BAD Banque Africaine de Développement

BIS Bank for International Settlements

BITs Bilateral Investment Treaties

CAC Collective Action Clauses

CAEMC Central African Economic and Monetary Community

CCL Contingent Credit Line

CDF Comprehensive Development Framework

CEEC Central and Eastern European Countries

CIS Commonwealth of Independent States

CMEA Council for Mutual Economic Assistance

CTT Currency Transactions Tax

DAC Development Assistance Committee

DDA Doha Development Agenda

DQRS Data Quality Reference Sites

ESAF Enhanced Structural Adjustment Facility

EBA Everything but Arms (EU trade policy initiative)

EEA European Economic Area

EBRD European Bank for Reconstruction and Development

EIB European Investment Bank

ESC UN Economic Security Council

EU European Union

FATF Financial Action Task Force on Money Laundering

FDI Foreign Direct Investment

FIAS Foreign Investment Advisory Service

FSAP Financial Sector Assessment Programme

FSF Financial Stability Forum

FSSA Financial System Stability Assessment

G7 Group of Seven leading industrialised nations (Canada, France, Germany, Italy, Japan, United Kingdom, United States)

G8 G7 plus Russia

3

R e s p o n s e s t o t h e c h a l l e n g e so f g l o b a l i s a t i o n

G20 Group of Twenty

GATT General Agreement on Tariffs and Trade

GDDS General Data Dissemination System

GDP Gross Domestic Product

GFCF Gross Fixed Capital Formation

GNP Gross National Product

GSP Generalised System of Preferences

HIPC Heavily Indebted Poor Country

HLI Highly Leveraged Institution

IBRD International Bank for Reconstruction and Development

ICAO International Civil Aviation Organisation

ICT Information and Communication Technologies

IDA International Development Association

IDB Inter-American Development Bank

IFMS International Financial and Monetary System

ILO International Labour Organisation

IMF International Monetary Fund

IPCC Intergovernmental Panel on Climate Change

ITO International Tax Organisation

LDC Least Developed Country

LIC Low Income Countries

LOLR Lender of Last Resort

LTCM Long Term Capital Management

ODA Official Development Assistance

OECD Organisation for Economic Cooperation and Development

OTC Over-the-Counter

MAI Multilateral Agreement on Investment

MEDA Euro-Mediterranean Partnership

MFN Most Favoured Nation

MIGA Multilateral Investment Guarantee Agency

MNE Multi-National Enterprise

NAFTA North American Free Trade Agreement

NPV Net Present Value

PIN Public Information Notice

PRGF Poverty Reduction and Growth Facility

PRSC Poverty Reduction Strategy Credit

PRSP Poverty Reduction Strategy Papers

PSI Private Sector Involvement

RTA Regional Trading Agreement

SDDS Special Data Dissemination Standards

SDR Special Drawing Right

SPS Sanitary and Phytosanitary Measures

STABEX System to Stabilise Export Earnings

SYSMIN System for Safeguarding and Developing Mineral Production

4

L i s t o f a b b r e v i a t i o n s

TBT Technical Barriers to Trade

WAEMU West African Economic and Monetary Union

UN United Nations

UNCTAD United Nations Conference on Trade and Development

UNDP United Nations Development Programme

UNFCCC United Nations Framework Convention on Climate Change

US United States of America

VAT Value Added Tax

WB World Bank

WEO World Economic Outlook

WTO World Trade Organisation

5

Executive summary (1)

This report responds to a request by finance ministers tothe Commission on 16 October for a study on the re-sponses to the challenges of globalisation. In line withthe terms of reference, the Commission has focused ontwo main issues: the discussion on the reform of the in-ternational monetary and financial architecture as a re-sponse to global financial crises and the issue offinancing and promoting development as a means to re-duce global inequality. While the report reviews some ofthe economic facts and features of the current globalisa-tion process, it does not focus upon many other impor-tant aspects of globalisation in the fields of social policy,health and environment. These topics are addressed inthe Commission’s communication ‘Towards a globalpartnership for sustainable development’, which sets theparameters for a comprehensive and balanced approachby the EU towards a global deal.

Given the limited time available and the broad scope ofthe terms of reference, the report does not include origi-nal research, but builds on existing literature. It attemptsto reflect some of the ongoing debate among academics,policy-makers and non-governmental groups as input fora policy discussion at Commission and Council level.

Globalisation: where do we stand?

Globalisation is a process that has been ongoing, albeitnot in a linear fashion, over a long period. Post-war glo-balisation has many facets. In the economic and financialsphere, which is the subject of this communication, it hasbeen characterised by a strong expansion of trade ingoods and services and, more recently, by a strong ex-pansion in capital flows. Several factors are underlyingthis growth process including technological progress,leading to dramatic reductions in transportation costsand an unprecedented increase in information-process-

ing capabilities, and public-policy measures, such as alowering of quantitative and tariff restrictions on tradeand the liberalisation of capital movements.

The process of globalisation over the past 50 years hasbeen accompanied by a six-fold rise in world outputwhile the global population increased about two and ahalf times. This translates into major improvements inthe income of a substantial part of the world’s citizensand into increased resources with which to tackle policychallenges. The past 50 years have further witnessed ma-jor improvements in other indicators of human welfareand quality of life in a large number of countries, includ-ing significant improvements in life expectancies atbirth.

Although correlation does not imply causality, there islittle doubt that the substantial increases in global percapita income that have been achieved would not havebeen possible without continued progress towards deep-er economic integration. Recent studies from the WorldBank confirm that developing countries that haveopened up their economies over the last 20 years havehad a growth performance superior to those that have notpursued international economic integration.

However, despite the overall increase in income andwelfare, the gap between richer and poorer countries andbetween richer and poorer segments of the populationwithin countries has probably widened. In particular, itshould be recognised that while globalisation is likely tobenefit overall those countries that are able to participatein it, it does create problems for certain categories of thepopulation. An example of this is the mixture of reducedrelative wages and employment opportunities that haveaffected low-skilled workers in industrialised countries.Public policies have an important role to play in tackling

¥1∂ This executive summary is based on the communication of the Commission to the Council, the Parliament, the Economic and Social Committee and the Commit-tee of the Regions entitled ‘Responses to the challenges of globalisation: A study on the international monetary and financial system’.

7


the difficulties faced by those that may lose from globali-sation, while ensuring that those countries that integrateinto the global economy are able to reap the overall ben-efits.

There also remains a group of, mostly very poor, coun-tries that are less integrated into the global economy andthat continue to be largely excluded from the benefits ofthe globalisation process. South Asia and Sub-SaharanAfrica lag far behind regions such as East Asia and thePacific. Their share in world trade has fallen, their termsof trade have deteriorated and they continue to be unableto attract foreign capital. Improving living standards andthe economic situation in these countries is one of themajor challenges for the global economy.

In addition, globalisation is associated with other chal-lenges such as communicable diseases, climate change,loss of biodiversity or lack of international security. Ad-dressing these issues — that is, providing the world withglobal public goods — can be seen as part of a strategyaiming at maximising the benefits of globalisation andminimising its negative effects. These global publicgoods benefit developing and industrial countries alike.They are an additional task to poverty reduction and theirfinancing should be explored.

The increased internationalisation of economic activitythat globalisation has brought raises issues about the ap-propriate level of economic policy-making and the ca-pacity of national governments to set rules andstandards. In this context, the report notes that over thecourse of the 20th century, the role of the State in eco-nomic activity has increased significantly in many devel-oped countries. This has been partly due to the post-wardevelopment of social safety nets and welfare systemsthat are seen to play an important risk-reducing role insocieties that are exposed to international competition.

The report also highlights the fact that since the end ofWorld War II, major progress was made in establishinga set of international and regional institutions and forumsthat provide international economic and financial gov-ernance. The current institutional arrangements are seento constitute a more robust set of institutions and forumsto deal with global policy challenges than existed duringprevious waves of globalisation. However, new emerg-ing challenges point to a number of inadequacies in thesystem, and reform proposals concerning various aspectsof this governance system are currently being discussed.

The international monetary and financial system in a globalised world

The Commission study looks in more detail into the ev-olution and the functioning of the international monetaryand financial system and finds that, overall, the systemhas functioned well over the past half century. It hascomplemented the strong growth in trade of goods andservices by channelling savings into productive invest-ment worldwide through open and well-functioning fi-nancial markets and by providing efficient clearing andsettlement systems. It has thereby contributed to globaleconomic growth and has allowed countries embracingsound policies to raise the living standards of their pop-ulation. The system has also been able to cope with peri-ods of disequilibria in balance-of-payments and hasensured monetary stability in times of financial stress.

Nevertheless, recent experiences have brought to thefore a number of real or potential systemic weaknesses,posing new challenges to policy-makers. Although theintegration of financial markets and the institutional andregulatory frameworks in which they operate havespurred economic growth, the international monetaryand financial system has continued to be crisis-prone.With the exception of the ERM crisis of 1993, the crisesof the 1990s have mainly affected emerging marketeconomies and, for most of them, have had importantconsequences in terms of output loss, welfare, socialconditions and unemployment. In addition, the changedinternational financial environment has been seen as al-lowing abuses in terms of money laundering, financingof illegal activities and tax evasion.

Recent years have seen the emergence of numerous pro-posals on how best to adapt the international monetaryand financial system to the changes and challenges of aglobal economy. The report reviews the current policydebate and provides a short analysis of the pros and consof the main reform proposals, their political and practicalfeasibility as well as an assessment of the necessary con-ditions for success. The reform proposals have beengrouped into four categories: modalities of crisis preven-tion and management, initiatives to reduce the abuses ofthe international financial system, regional and globalcooperation, and reform of the institutional framework.

Modalities of crisis prevention and management

The proposed solutions are numerous: they range fromvery modest ones, such as increasing and improving the

8

E x e c u t i v e s u m m a r y

flow of information to market participants, to very ambi-tious ones such as the creation of a single world curren-cy. Some initiatives are in the process of beingimplemented, reflecting a high degree of consensusamong the international financial community; otherslack at present sufficient political support or would im-ply too high a level of public interference in the markets.Whereas most of the proposed changes could be dealtwith within the existing framework, some of the moreambitious ones would require the creation of a new insti-tution or a much more profound reform of the interna-tional financial architecture.

At the crisis-prevention level, suggestions for furtherprogress that are broadly accepted include increasingtransparency in policy design and implementation, andimproving the flow of information to market partici-pants; developing and deepening financial markets andstrengthening domestic financial systems to make coun-tries less vulnerable to crises; and strengthening the for-eign exchange reserves of emerging market economies.Their implementation by many countries is already con-tributing to making the system more predictable andmore resilient to shocks.

Progress is also being made on other fronts but at a slow-er pace because these proposals are either of a less con-sensual nature or more difficult to implement in practice.These proposals include the development of early-warn-ing systems; the introduction of collective action clausesinto new international bond issues of emerging marketeconomies; the creation of clubs of creditors; the devel-opment and use by emerging market economies of fi-nancing instruments that can be used as a first line ofdefence in case of crisis; and the need to ensure an order-ly and well-sequenced capital account liberalisationprocess.

Finally, there are a number of proposals that have yet togather sufficient support by policy-makers and which of-ten require important institutional changes, the merits ofwhich need to be carefully weighed. Establishing an in-ternational debt insurance agency, creating an interna-tional prudential supervisory agency or introducing acurrency transactions tax are among the more visibleproposals.

While not claiming to be exhaustive, the report pays par-ticular attention to the use of a currency transaction taxas a tool to stabilise exchange markets. Proponents of atax on international currency transactions argue that it

would contribute to exchange-rate stability by reducingarbitrage and speculation. The literature, however, sug-gests that the tax may actually increase volatility, as trad-ing volumes are likely to fall significantly following itsintroduction.

At the crisis-resolution level, a topic high on the interna-tional agenda is to find the proper balance between ad-justment by the debtor country, official financing, andprivate financing. This balancing exercise has becomemuch more complex than 20 years ago. The questionalso arises whether, and to what extent, the balanceshould be tailored to specific country circumstances.This highlights the importance of making furtherprogress in clarifying and developing further the princi-ples for private-sector involvement in both the preven-tion and the resolution of financial crises. Theinternational community has also recently recognisedthe need to analyse how a clearer and more solid legalframework for debt standstill, debt restructuring, anddebt reduction could contribute to facilitate orderly crisisresolution. Here too, some proposals imply more signif-icant institutional changes.

Reducing the abuses of the international financial system

The use of the international financial system for illicitpurposes has become a major concern. Characterised bya high degree of openness and decentralisation, the sys-tem is being used for criminal activities, including mon-ey laundering and the financing of terrorism, for taxevasion and for the circumvention of regulations. Insome cases, corporate entities are deliberately createdfor such purposes. The abuse problem is compounded bythe existence of a number of countries and judicial terri-tories that see their comparative advantage in grantingfavourable tax and regulatory environments for non-res-ident funds. Financial abuses can threaten the credibilityand undermine the integrity of the international financialsystem and affect countries at every stage of develop-ment.

In response to these challenges, international collabora-tion has been intensified through existing forums and or-ganisations, such as the G7 Finance Ministers, OECDwork on harmful tax practices and the Financial ActionTask Force on Money Laundering and on the Financingof Terrorism. The Financial Stability Forum establishedin 1999 has worked on a variety of questions, includingthe activities of highly leveraged institutions and off-shore financial centres. Specific actions have been taken

9


against terrorist financing. In line with UN SecurityCouncil resolutions, assets of targeted persons and or-ganisations associated with the Taliban have been fro-zen. Increased corporate transparency and betterintegrated supervisory systems are seen as necessaryconditions to prevent the misuse of corporate vehiclesfor illicit purposes.

A common challenge to most of the proposals reviewedis the question of how to ensure compliance of non-sig-natory third partners. It is sometimes argued that bettercompliance with international rules and practices couldresult from improved coordination between the existinginstitutions engaged in related projects. Furthermore, thefight against unfair practices has to be placed in thebroader context of a coherent and sustainable approachto development.

Regional and global cooperation

The study also reviews initiatives to enhance the stabilityof the international monetary system through intensifiedmacroeconomic coordination within the context of re-gional groupings and among the three major currency ar-eas (G3). Regional macroeconomic and monetarycooperation are frequently seen as a way of strengthen-ing economic integration, growth and stability. The in-troduction of the euro provides an example of successfulregional integration that has not only been beneficial forEurope but also is likely to contribute to the stability ofthe international monetary and financial system. Al-though the European experience cannot be translated di-rectly, it provides an example to other regions of theworld. While Asian economies have made progress inenhancing financial and monetary cooperation in the re-gion, monetary cooperation policy has, so far, played noor only a negligible role in the design of regional eco-nomic integration schemes in the Americas. This raisesquestions about the compatibility of different exchange-rate systems with the objective of regional integration.

Against the background of growing economic and finan-cial interdependence, and the potential for more suddenand deeper spillovers of shocks between the three majorcurrency areas, a number of proposals advocate somekind of exchange-rate coordination between the G3. Pro-ponents argue that the targeting of exchange rates amongthe G3 currencies would increase the overall stability ofthe international monetary and finance system, implyingfewer crises and higher growth for both the major cur-rency areas as well as for emerging economies and de-

veloping countries. Others claim that this would implythat monetary policy authorities would lose to a signifi-cant degree the ability to react independently to externalshocks and domestic policy priorities.

Towards improved governance of the international monetary and financial system

Discussions on improving the governance of the interna-tional monetary and financial system often focus on theInternational Monetary Fund (IMF), where significantdecision-making power related to the international mon-etary and financial system is vested. Over the past 50years, the institution has been able to accommodate asubstantial increase in both its membership, thereby be-coming a quasi-universal institution, and in the scope ofits mandate. Recently, however, there have been callsfrom emerging market economies, NGOs and nationalparliaments for more legitimacy, more accountability,and better governance for the Fund. Progress has beenmade to address these concerns, including through in-creased transparency of the IMF decision process;through the creation, outside the IMF, of groups such asthe Financial Stability Forum and the G20; and throughthe transformation of the Fund’s Interim Committee intoa more permanent International Monetary and FinancialCommittee. However, proposals with a greater institu-tional content, such as transforming the InternationalMonetary and Financial Committee into a Council withdecision power and re-balancing the decision powerwithin the Fund have made little progress or are still un-der review.

The report also reviews proposals to create new over-arching bodies, such as a Global Governance Group or aUN Economic Security Council. Such initiatives wouldrequire widespread political support to be initiated.

Promoting and financing development

A number of poor countries have been largely unable toparticipate in the benefits of globalisation. They aretrapped in a situation of low income and poverty, lowlevels of education and investment and sometimes highindebtedness. For these countries, international assist-ance is crucial. The report reviews four existing develop-ment instruments: official development assistance; debtrelief; trade measures; and promotion of foreign directinvestment. In addition, the report discusses some alter-native sources of financing for development, includingproposals for international taxes.

10


Official development assistance

Overall, trends in official development assistance(ODA) have been disappointing. Official developmentassistance by major donors in terms of their GNP de-clined from 0.33 % in 1990 to 0.22 % in 2000 (0.33 %for the European Community) and thus further awayfrom the aid target of 0.7 % originally put forward by the1969 Pearson report. The measurement of ODA has alsobeen criticised for over-estimating the true level of ODArelative to that which would have been recorded had theoriginal definition been strictly applied. The World Bankhas recently estimated that current levels of ODA wouldneed to be doubled in order to help low-income countriesto reach their millennium development goals of halvingpoverty between 1990 and 2015.

In addition to concerns related to the level of ODA, thereis a need to ensure an effective use of existing ODA re-sources. The debate on the effectiveness and quality ofaid has led to the identification of a number of importantelements, such as prioritisation, coordination, condition-ality and ownership of policies, policy coherence and un-tying of aid, which are increasingly being taken intoaccount by the EU and other major bilateral and multilat-eral donors.

One example is the debate on conditionality and owner-ship, which is related to the observation that economicreforms can be supported but ‘cannot be bought’. Thisimplies that conditionality on adjustment lending willstimulate reforms better if they are in line with the gov-ernment’s own programme. As a result, bilateral andmultilateral donors now emphasise partnerships amonggovernments, development-cooperation agencies, civilsociety, and the private sector, in order to stress countryownership of the process. There is also a tendency to-wards refocusing aid towards ‘good policy — high pov-erty’ countries, where the effectiveness of aid is seen tobe highest.

The effectiveness debate also focuses on the requirementby some donor countries that the recipient countrysource public procurement from companies in the donorcountry. OECD studies demonstrate that tied aid increas-es the cost to recipient countries of many goods and serv-ices by between 15 and 30 %. There are therefore strongarguments in favour of ‘untying’ aid, which were givennew momentum when, in May 2001, donors agreed on aDAC (Development Assistance Committee) recommen-dation to untie ODA to the least developed countries asof 1 January 2002.

The fragmentation of aid and poor coordination have fre-quently been a major obstacle to aid effectiveness. Theprocess of recipient country-led poverty-reduction strat-egies should provide common ground for improving do-nor action at country level in many of the poorestcountries. Within donor countries, the promotion of co-herence between development policies and those oftrade, security, investment, social policies and the envi-ronment continues to be a major challenge.

Debt relief

The report reviews progress with respect to alleviatingthe debt burden of developing countries, which saw theirdebt relative to GNP double between 1981 and 1998,with a slight decline in the following years. After repeat-ed debt-relief actions provided by official bilateral andprivate creditors, the HIPC debt initiative launched in1996 dealt for the first time with the debt owed to multi-lateral institutions. The HIPC initiative was enhanced in1999 to provide deeper, broader and faster debt relief andit is generally recognised that the initiative constitutes animportant step in the right direction towards helpingpoverty reduction.

Apart from the issue of ensuring a rapid implementationof this initiative, there is a continued debate whether thisaction is sufficient to ensure sustainability and povertyreduction, even though the responsibility of the benefici-ary countries in pursuing the right policies remains keyto its long-lasting impact. There is also a discussion onwhether enough countries are covered by this initiative.For poor countries in conflict, which are in principle eli-gible, but have not yet qualified, action has been taken bythe G7 to reinforce political dialogue. Proposals havealso been made to extend the initiative to more countriesthan the 42 HIPCs, but this comes up against significantfinancing constraints.

Trade measures

As several studies reviewed in the report have shown,trade openness is a necessary, albeit not sufficient, con-dition for economic growth and thereby poverty reduc-tion. Progress in this respect is conditional uponappropriate flanking policies, supported by trade-relatedcapacity building and further trade liberalisation by allcountries, including developing countries themselves.

Although a number of developing countries have be-come more integrated into the world economy in recentyears, they are too often disadvantaged as regards market

11


access. Agricultural and labour-intensive manufacturedgoods (such as textiles), where developing countries’comparative advantage often lies, frequently face thehighest trade barriers in developed and developing coun-try markets, although the impact of such tariff peaks is tosome extent offset by preferential access to developedeconomies. Initiatives such as the EU’s ‘Everything butarms’ initiative launched in early 2001, help to removethese distortions for least developed countries (LDCs)’exports to the EU. The adoption of such initiatives byother major developed countries, in line with commit-ments taken at the third UN Conference on LDCs in2001, could bring further benefits to LDCs.

At multilateral level, the Doha WTO ministerial confer-ence in November 2001 launched an ambitious negotiat-ing agenda of trade liberalisation underpinned by strongand transparent multilateral rules — the Doha Develop-ment Agenda — which offers the prospect of significantgains to all WTO members, with a particular focus on theneeds of developing countries. At regional level, region-al trade agreements can provide an important stimulus tointegration with the global economy and can reinforceregulatory cooperation, locking in reforms and providingclarity and consistency to potential investors. Such regu-latory cooperation should, whenever possible, be basedon agreed multilateral norms and attention should begiven to potential additional administrative costs for de-veloping countries and the provision of adequate techni-cal assistance.

Promotion of foreign direct investment

In recent years, foreign direct investment (FDI) has re-ceived increasing interest from policy-makers due to itsgrowing importance for both developed and developingcountries. Flows of direct investment towards develop-ing countries increased seven-fold between 1990 and2000, although they have been heavily concentrated in alimited number of countries (middle-income countriescapture 93 %) and make up less than one fifth of worldflows. FDI can potentially play an important role for eco-nomic development and hence poverty reductionthrough employment creation, technology transfers, pro-ductivity increases and enhancement of export capacity.However, according to the studies reviewed, some spe-cific conditions are needed for this potential to be real-ised. The notion of ‘absorptive capacity’ arises, as it hasbeen demonstrated that a minimum level of knowledgeis necessary to absorb the foreign technology. Similarly,to avoid monopolistic behaviour by powerful multina-tional firms, appropriate use of competition policies and

their effective enforcement can be a useful instrument.Finally, a liberalised trade regime is a complementarytool to maximise efficiency and fully benefit from thepotential of FDI to enhance the export capacity of thehost country.

As far as active government investment-promotion poli-cies are concerned, their desirability is not entirely clear.FDI is primarily determined by exogenous factors, suchas geographical position, market size and availability ofnatural resources. Beyond these, necessary conditionsinclude economic, political and regulatory fundamentals(such as the rule of law) that ensure a stable environmentfor foreign investors. These factors are mainly the re-sponsibility of local governments. The main role andchallenge for international institutions is to create mech-anisms that facilitate FDI more globally. Many also ar-gue that developing countries would benefit from amultilateral framework of rules for investment thatwould be cost-effective, transparent and stable and en-sure non-discrimination.

Alternative financing instruments

The report looks into several alternative sources of fi-nancing that have been proposed, including internationaltaxes, the ‘de-tax’ and the allocation of special drawingrights (SDRs). In addition to generating financing for de-velopment, international taxes are being discussed as away to contribute to the provision of global publicgoods. The taxes discussed in the report are a tax on in-ternational currency transaction, a tax on carbon dioxideemissions, a tax on aviation fuel and a tax on arms ex-ports.

All the international tax proposals reviewed in the reportfollow a dual objective. While they aim to raise revenueas a means of funding development and/or the provisionof global public goods, they also have the purpose of mo-tivating changes in behaviour by modifying relative pric-es and hence of correcting international economicdistortions and contributing to the provision of globalpolicy objectives, such as financial stability, the protec-tion of the global environment and the prevention of con-flict.

While as a source of additional revenue a currency trans-action tax may look appealing, its feasibility is, however,not demonstrated. Various proposals have been put for-ward, but even if applied in the settlement system, issuessuch as the enforcement of the tax and the preservationof the tax base need to be addressed. To be sustainable,

12


such a tax would most likely require a multilateral ap-proach, including the compliance of the major interna-tional financial centres.

An international carbon tax as well as a tax on the con-sumption of aviation fuel have been discussed as meansto internalise the negative environmental effects of car-bon dioxide and other types of emissions by increasingthe costs of emission. In terms of potential revenue, aglobal carbon dioxide tax might be the most promising;at international level, however, the political momentumhas shifted to non-tax economic instruments such asemissions trading.

There is general acceptance that the international prolif-eration of arms has significant negative implications forinternational security and the taxation of trade in armshas been suggested as a way to curb this trade. While inprinciple the taxable base (production or trade) can bedefined, there are various challenges and obstacles inpractice. These include the lack of transparency in inter-national arms trading and the voluntary nature of the ex-isting international frameworks. Taking into account thedata uncertainties characteristic of the international armsmarket, the revenue potential of a tax on arms trading isexpected to be limited.

International taxes need to be administered. Collection atnational level will require a very high degree of coordi-nation among countries, while establishing a new inter-national body raises a lot of additional issues, includingthose related to democratic control and transparency.

While more work needs to be done to validate these pro-visional conclusions on international taxes, it seems thatmeeting needs for enhanced financing of developmentand for the provision of global public goods in the shortto medium term will require more substantial contribu-tions from national budgets and a further increase in theefficiency of resource use than is presently the case.

Proposed as an alternative to compulsory financingthrough taxation, the ‘1 % de-tax’ scheme advocated bythe Italian Government builds on voluntary consumerand vendor decisions to earmark 1 % of the purchase atretail level to an international development project. Thegovernment would exempt this contribution (‘de-tax’)from VAT and company income tax. While this sourceof enhanced voluntary contributions lacks the predicta-bility of tax-based revenues, it has the advantage that itcan be introduced unilaterally.

An SDR allocation (a selective one targeted at the poorcountries or a general one whereby industrialised coun-tries pool their new SDRs for use by developing coun-tries) has also been proposed as a way to provideadditional financing for development purposes. Ulti-mately, however, SDRs are not a free lunch. They con-stitute a right of a country to obtain a short-term creditwith another country, the one that it buys currency from,at a specified interest rate. Conceived in the 1960s as atool to supplement a perceived shortage of internationalliquidity at world level, using an SDR allocation as away to provide unconcessional long-term credit to devel-oping countries does not seem to be a suitable approach.

13

Chapter I

Globalisation:where do we stand?

Introduction

Globalisation can be characterised as a trend towardsgreater integration and interdependence between coun-tries and regions of the globe. These growing linkagesare often economic and political, but globalisation alsohas important social, environmental and cultural aspects.This introductory chapter focuses upon the economicaspects of globalisation, by looking at trends in interna-

tional flows of goods and services, capital and labour(Section A) and seeking to identify some of the drivingforces (Section B). It highlights the benefits that accrueto countries and regions that integrate successfully withthe global economy (Section C), but also identifies someof the limitations of current globalisation and the impor-tant public-policy challenges that remain (Section D).

17

A. Current globalisation trends

This section of the chapter describes trends in interna-tional flows of economic factors of production: goodsand services, capital and labour.

Trade in goods and services

When examining the economic interdependence of theglobe, one obvious approach is to look at trade flows.Figure 1 compares the post-war evolution of world tradevolumes in goods compared to world real GDP. A six-fold increase in global output has been accompanied bya 20-fold expansion of global merchandise tradeflows (1). Merchandise trade growth was particularlystrong during the 1990s. World trade in services alsogrew at a fast rate through the 1990s: more than doubling

from ECU/EUR 530 billion to EUR 1 194 billion (2) be-tween 1992 and 2000. Whilst some services are inherent-ly difficult to trade (the classic example being a haircut),more and more services are becoming tradable (3).

The composition of trade in goods and services has alsoevolved over time. Rich countries increasingly tradesimilar, but differentiated, goods and services betweenthemselves (intra-industry trade). Multinational firmsnow play an important role in the global economy andare frequently able to slice their production chain inter-nationally, thus contributing to the estimate that roughly30 % of world trade in manufactures is in intermediate

¥1∂ There is a sizeable literature that argues that increased trade leads to highereconomic growth, e.g. Frankel and Romer (1999).

¥2∂ Eurostat news release 117/2001 (2001). Note that this data excludes intra-EU trade.

¥3∂ The dynamic growth of trade in services is boosted by growth in FDI, dis-cussed later in the section.

Figure 1: Trends in world trade in goods (volume) v GDP (1990 = 100)

Source: Commission services based on WTO (2001).

0

20

40

60

80

100

120

140

160

180

200

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Exports (volume)

GDP

18

C h a p t e r IG l o b a l i s a t i o n :

w h e r e d o w e s t a n d ?

rather than final goods (Yeats, 1998). Developing coun-tries are playing an increasingly significant role in man-ufacture trade. The World Bank (2002) reports that theshare of manufactures in developing country exportsrose from 25 % in 1980 to 80 % in 1998. Increasingamounts of trade now flow between developing coun-tries (1), but the poorest countries continue to play only amarginal role in international trade (2). Some countries,in particular those of sub-Saharan Africa, have seen theirshare in world trade drop during the last two decades andhave experienced a deterioration of their terms of trade.

International flows of capital

The extent of international flows of capital and of the infor-mation needed to make investment decisions can providefurther evidence of international economic interdepend-ence. Today, gross flows of short-term capital in particularare huge by long-term historical standards. The latest Bankof International Settlements data report average daily for-eign exchange market turnover at USD 1 210 billion inApril 2001. This is roughly double the figure for 1989, buta decline of 19 % on 1998 (3). Daily turnover in over-the-counter derivatives, such as swaps and options, reachedUSD 575 billion in April 2001, compared to USD 151 bil-lion in 1995 and USD 265 billion in 1998. A report by theFinnish Ministry of Finance (2001) notes (4) that gross di-rect investments by industrial countries rose steadily be-tween 1993 and 1998, from USD 212 billion to USD 585billion per year. The financial information that underpinsinvestment decisions flows around the globe to investorswho possess the appropriate technology almost instantane-ously and in huge volumes nowadays. International capitalnow also flows into a wider range of economic activitiesthan previously (CEPR, 2001). Late 19th century interna-tional capital flows, for example, were heavily focusedupon infrastructure construction projects, such as railways.

There remains, however, a debate about the true extentof current global capital market integration relative toprevious historical periods. Bordo et al. (1999) arguethat a combination of slower technology for transferringfunds, information asymmetries, legal uncertainties, and

the absence of adequate accounting standards limited thetrue extent of financial market integration in the late19th century. In general, these imperfections are less sig-nificant today, but persist to some degree.

One way of assessing the degree of international capitalmarket integration is to look at the absolute size of thecurrent account relative to GDP. This is equivalent to thenet capital in- or outflow, and thus provides a simple, ifsomewhat crude, indication of capital market integra-tion (5). Another indicator of international capital mobil-ity is the correlation between domestic saving anddomestic investment. In a world of perfect capital mobil-ity, there should exist no systematic relationship be-tween domestic saving and domestic investment (6),since the savings of residents in any given countryshould be allocated to the investment project yielding thehighest return, wherever it is geographically located.

Figure 2 presents these two indicators averaged across12 major countries (7) for the period 1870 to 1989. Thecurrent account data (the unweighted mean absolute av-erage relative to GDP) show that larger proportional netflows of capital were occurring at the beginning of the20th century than during the 1980s. According to thedata on domestic savings/domestic investment correla-tion, international capital market integration was onlybeginning in the 1980s to get back to the level of the late19th century. However, the data set contains only a lim-ited group of countries and there remains much debateabout the appropriate methodology for assessing andcomparing international capital mobility (8).

The structure of the capital flows described above hasbeen evolving over time. In the Gold Standard era up un-til World War I, bonds were the dominant means of rais-ing long-term capital. After the collapse of the BrettonWoods system in the early 1970s, syndicated banklending became the dominant instrument. The position

¥1∂ IMF and World Bank Staff (April 2001).¥2∂ For example, WTO (2001) reports that in 2000 the merchandise exports of

Africa, excluding South Africa, were USD 115 billion, compared to EUexports of some USD 2 251 billion.

¥3∂ Daily turnover in 1998 was USD 1 490 billion. The BIS cites the launch ofthe euro, the growing importance of electronic broking, and banking con-solidation as likely factors for the decrease in 2001.

¥4∂ Based on IMF (1999).

¥5∂ Note that a country which both exports and imports large amounts of capi-tal could still record an absolute current account balance of zero, if thedebits and credits match and thus ‘cancel out’. More generally, it is impor-tant to underline that, because of these compensatory flows, net capitalflows, as commonly used, give a vision of financial integration which isheavily underestimated. This is particularly visible in the case of short-term capital flows between affiliated companies, which are part of FDI andhave reached very high levels, but do not generally appear in net flows,although recent trends to centralise financial departments in multinationalcompanies have made them more visible.

¥6∂ This idea is often referred to as the Feldstein-Horioka puzzle after a 1980paper that examined it.

¥7∂ Argentina, Australia, Canada, Denmark, France, Germany, Italy, Japan,Norway, Sweden, UK, United States.

¥8∂ Taylor (1996) discusses some of these issues.

19


changed again in the 1990s as foreign-direct investment(FDI) grew markedly in importance, with equity finance,bonds and bank lending also playing a role (Figure 3).Financial crises featured in all of these periods (1).

Crafts (2000) highlights the growing importance of FDIand points out that multinational enterprises nowadaysplay an increasingly important role in the global econo-my. Unctad numbers multinationals in tens of thousandstoday, compared to only a few hundred at the end of the19th century. Craft notes that the value of the US FDIstock in 1996 stood at around 20 % of GNP; comparedto roughly 7 % in 1914. More generally, it is estimatedthat production by overseas facilities of multinationalsrepresents a sixth of global industrial production.

A recent study by Venables et al. (2001) for the Europe-an Commission also emphasises that FDI flows may linkeconomies more strongly than trade flows alone suggest.For instance, it is reported that EU companies’ subsidi-aries in the United States have sales in the United Statesthat are 3.6 times greater than the EU’s exports to theUnited States. This increased FDI is not evenly distribut-ed globally, however. The Unctad World Investment re-

port (2001) points out that for 1998 to 2000, the EU,Japan and the United States accounted for 75 % of in-flows and 85 % of outflows of FDI. The same regionscombined account for roughly three fifths of worldwideinward FDI stocks and four fifths of outward stocks.

International flows of labour

As a result of much lower transport costs, people travelaround the globe far more than they used to. As a basicindication, the ‘ATW world airline report’ (2000) statesthat in 2000, total world traffic reached 1.82 billion pas-sengers. A significant proportion of these journeys willnot have been made for work purposes, but internationalbusiness trips and short-term stays in foreign countriesare facets of current globalisation.

However, long-term, international economic migration isnot occurring on a huge scale by historical standards, inspite of the significant migration pressures that exist cur-rently in a global economy in which wages for workers withsimilar skills vary hugely between countries at differentstages of development (2). The data in Figure 4 clearly show

Figure 2: Correlation between domestic saving and domestic investment, and current account as a % of GDP for 12 major countries

Source: Commission services based on Baldwin and Martin (1999).

0

1

2

3

4

5

1870

–79

1880

–89

1890

–99

1900

–09

1910

–19

1920

–29

1930

–39

1940

–49

1950

–59

1960

–69

1970

–79

1980

–89

Current account/GDP (%)

Cur

rent

acc

ount

/GD

P (

%)

0

0.2

0.4

0.6

0.8

1

Saving–investment correlation

Savi

ng–i

nves

tmen

t co

rrel

atio

n

¥1∂ Kindleberger (1996).

¥2∂ World Bank (2002), p. 44 cites a study that followed individual legalmigrants. Workers moving from Mexico to the United States found theycould increase their wages from USD 31 per week to USD 278 per week.

20



that immigration into the United States was much higher atthe beginning of the 20th century than more recently (1).

Large-scale legal immigration into western Europe wasat its height in the high-growth decades that followedWorld War II, as countries such as France and the UKaccepted many immigrants from their former colonies.Germany also accepted large numbers of guest workersduring this period. From 1960 to 1973, the proportion offoreign workers rose from 3 to 6 % of the workforce(Hall, 2000). This so-called ‘primary’ immigration de-clined very considerably after 1973.

¥1∂ Hall (2000) reports an estimate that the United States accepted about 1 millionimmigrants — of which roughly 300 000 were illegal immigrants and refugees— annually in the late 1990s, relative to a population of about 275 million.

Figure 3: Composition of private-capital flows (1973–81, 1990–97)

Source: World Bank, Global Development Finance (2000).

Figure 4: Long-term trends in US immigration

Source: Crafts (2000) based on US Bureau of the Census data.

0

10

20

30

40

50

60

70

Bank lending FDI Bonds Portfolio equity

Per

cent

age

of t

otal

1973 – 81 1990 – 97

0

2

4

6

8

10

12

14

16

1870 1890 1910 1930 1950 1970 1990

Immigration rate/1 000 population Foreign born as % of population

21

B. Forces driving globalisation

Globalisation is a process that has been ongoing, albeitnot in a linear fashion, over a long period (1). The processis facilitated and driven by interrelated changes in tech-nology, especially in communications and transporta-tion, public policy — both domestically and atinternational level — and the preferences of individualcitizens regarding what and where they wish to consume,save and work (2).

Technological progress

Technological progress has boosted the efficiency withwhich goods, services, capital, ideas and people movearound the globe and has been a major driving force behindmany of the phenomena described in the previous section.Figure 5 shows some of the technologies that have spurredthis globalisation and demonstrates the steep price falls thatoccurred through the 20th century. More recent advancesin information technology are discussed in detail in IMFWEO (Autumn 2001). An example of the precipitous pricefalls that have occurred for this technology is provided inMasson (2001): between 1960 and 2000, the price of ‘com-puters and peripheral equipment’ relative to the GDP de-flator fell by a factor of over 1800. Relative cost reductionson this scale make the technology widely available andhave been instrumental in hugely increasing global infor-mation flows, for instance via the World Wide Web, whichallow knowledge and new ideas to be disseminated aroundthe globe more rapidly and in greater volume.

¥1∂ World Bank (2002) argues that the term ‘globalisation’ is not appropriatepre-1870, whereas Mussa (2000) considers that the process has been ongo-ing since at least the Renaissance.

¥2∂ An example of these interlinkages is provided in Mussa (2000): ‘[…] cen-turies ago, wealthy people in Europe first learned about the tea and spicesof the East as the consequence of limited and very expensive trade. Thebroadening desire for these products […] hastened the search for easierand cheaper means of securing them. As a by-product of these efforts,America was discovered, and new frontiers of integration were opened upin the economic and other domains.’

Figure 5: Relative transportation and communications costs

Source: World Bank (1995).

0

10

20

30

40

50

60

70

80

90

100

1920 1930 1940 1950 1960 1970 1980 1990

Rel

ativ

e pr

ice

inde

x Ocean freight

Air

SatelliteTransatlantic phone

22



Public policy

In addition to technological progress, public policycontinues to play a crucial role in determining the ex-tent to which countries participate in globalisation. Asthe inter-war period demonstrates, policy measureshave at least the potential to reduce greatly the extent towhich nations interact with one another, and so, at leasttemporarily, to reverse the course of globalisation.Since World War II, policies in many countries, albeitwith exceptions, have generally been supportive of in-ternational economic integration. Over this period, in-dustrialised countries progressively opened theireconomies and a number of developing economies alsobegan a process of external liberalisation, particularlyafter 1980 (1). In addition, the historic policy changesthat signalled the end of the cold war in the late 1980sand early 1990s meant that a substantial number ofcountries became, to a far greater extent than had pre-viously been the case, open to international flows ofgoods, services, people and ideas.

There remains, nevertheless, a significant group of coun-tries that, partly due to policy choices, are not participating

in the process of globalisation. However, dramatically im-proved communications technology means that citizens,even in very poor countries, are much better informedabout political conditions and standards of living else-where. Technological progress itself may thus contributeto pressures for policy changes.

More generally, some authors have made a link betweenincreased globalisation and the growth of the role ofStates in economic activity over the course of the lastcentury (Figure 6).

Rodrik (1996) provides a theoretical justification for this byclaiming that higher government consumption and intra-so-cietal transfers play a risk-reducing role in societies ex-posed to greater external competition and thus uncertainty.

In addition, the 20th century, and in particular the periodimmediately after World War II, witnessed the creationof several international institutions and forums thatprovide governance at a level beyond national borders.These include the Bretton Woods institutions, theGATT/WTO and the wider United Nations system,which provides governance mechanisms in many fieldsthrough its programmes, funds and specialised agencies.Regional governance initiatives have also flourished in¥1∂ World Bank (2002a).

Figure 6: Total government outlays relative to GDP (1913, 1960, 2000)

Source: Commission services based on IMF and OECD data.

0

10

20

30

40

50

60

France Germany UK United States

Gov

ernm

ent

expe

ndit

ure/

GD

P (

%)

1913 1960 2000

23


the 20th century, with the EU by far the most advancedregional example of supranational governance.

Part of the growth in the number of international organ-isations and agreements in many policy areas is due to at-tempts to deliver coherent international rules. Anothermajor driver for the increasing economic role of govern-ments and the creation of international bodies has beenthe ex post recognition of the limitations and failures ofthe previously existing institutional arrangements. Thisis particularly true of the period immediately after WorldWar II. If the process of globalisation continues in futureas it has during the past 50 years, it would seem likelythat yet more traditionally domestic issues will become‘international’, implying that the trend towards the needfor increased supranational decision-making has yet torun its course.

The remainder of this section looks at some specifictechnological and public-policy factors that have influ-enced the developments in international trade, capitaland labour integration described above.

Trade flows

The rapid growth in post-war international trade haspartly been due to reductions in transport costs, such asthose described in Figure 5, but has also been the resultof lower tariffs and trade barriers. Table 1 shows the ev-olution in the tariffs of selected major industrialisedcountries over the past 125 years. The positive post-wardevelopments shown are not without their limitations,however. Protection remains high in agricultural andtextiles sectors in most countries, and industrialisedcountries continue to apply relatively high tariffs on asmall number of manufacturing sectors. Most develop-ing countries continue to apply comparatively high tar-iffs across the board (1) even in manufactures. Thepoorest countries generally trade very little. With the re-duction in tariff levels, non-tariff barriers to trade, suchas product standards and anti-dumping regulations, havealso become more important in recent years.

Nevertheless, the GATT/WTO, set up shortly afterWorld War II, has been a major innovation to the globaltrading system compared to the pre-war situation. Ta-ble 1 shows the rise in protectionism that occurred dur-ing the 1930s. No similar rise has occurred to dateunder the GATT/WTO, which has delivered consecu-tive reductions in the applied tariffs of its members andcontributed to the elimination of quantitative restric-tions, in parallel to creating a rules framework that pro-vides greater predictability and transparency ininternational trade relations. Although heavily criti-cised from certain quarters in recent years, the GATT/WTO, via the fundamental principles of MFN (most fa-voured nation) treatment, non-discrimination andtransparency and the binding of tariff obligations, has

delivered a significantly more robust trading architec-ture than had existed previously.

Regional trading agreements (RTAs) have grown innumber since World War II, particularly during the1970s and 1990s. The EU, for example, has succeeded incompletely removing tariff and quota restrictions ontrade between members and has removed many non-tar-iff barriers to internal trade. Although a second best com-pared to multilateral liberalisation (bilateral agreementsmean that non-members are discriminated against), theregional integration path can be used as a stepping stonetowards developing countries’ full integration in the in-ternational trade system. In particular, such arrange-ments can be an effective means of supporting the

¥1∂ For example, India’s simple average bound tariff for manufactures afterthe Uruguay Round is 58.7 %, WTO (2000).

Table 1

Selected tariff levels over the past 125 years

1875 1913 1930 1950 1989 Post-Uruguay Round

France 12–15 20 30 18

Germany 4–6 17 21 26

United Kingdom 0 0 17 23

United States 40–50 44 48 14 4.6 3.0

EU 5.7 4.6

Source: Source: Crafts (2000).

24



improvement of their domestic policy environment andtheir ability to create a climate conducive to economicgrowth and social development. In this context, there arestrong arguments that ‘deep’ RTAs that involve servicesand regulatory liberalisation should be based uponagreed multilateral norms.

Regional integration may also allow for efficiency gainsin the regional market, which can pave the way for en-hanced competitiveness in the world market and higherlevels of investment and growth. In addition, RTAs offeruseful forums for smaller countries to make their viewsheard internationally. However, unchecked regionalismhas at least the potential to divert more trade than it cre-ates and to undermine the primacy of the WTO as themultilateral rule-making body for international trade.

Capital flows

The extent of international capital market integration de-pends heavily upon which policy instrument of interna-tional macroeconomics’ ‘impossible trinity’ of monetarypolicy, exchange-rate policy and capital account con-vertibility countries choose to relinquish. At the end ofthe 19th century and up to 1914, the single global curren-cy of the gold standard meant no domestic monetary pol-icies, but encouraged international capital flows. Thepost-war Bretton Woods system on the other hand, al-lowed domestic monetary flexibility and fixed exchangerates given capital controls. Since the break-up of theBretton Woods system, flexible exchange-rate systemshave made a comeback (1) and so have international cap-ital flows, as countries have been able to liberalise theircapital account. These policy choices partly explain thetrends in Figure 2.

Technological progress has played a key role in fosteringfaster and more efficient trading of traditional financialinstruments and in the development of more complex fi-nancial products. Information technology has also ena-bled huge quantities of data to be sent around the worldinstantaneously and at minimal per unit cost. The grossdaily trading volumes reported above are largely facili-tated by information technology. Better informationflows also facilitate the geographical and sectoral broad-

ening of capital flows as lenders are better able to moni-tor borrowers.

Technological advances and innovations in methods ofdoing financial business provide part of the explanationfor the changing composition of private-capital flows.The 1990s surge in FDI is partly due to the growth ofmultinational enterprises and to many countries adopt-ing favourable policies towards FDI. The trend was fur-ther supported by new FDI opportunities as a result ofthe ‘opening up’ of numerous former Soviet bloc coun-tries, and the continued opening of countries such asChina.

As in the trade sphere, the aftermath of World War II sawthe creation of institutions (the IMF, in particular) to pro-mote more stable international financial interaction. Fur-ther bodies were added to the governance structure ofinternational finance as the century progressed. Al-though these institutions and bodies must adapt and de-velop to external developments, as in the trade sphere,global financial policy-makers have a more mature set offinancial bodies and institutions at their disposal nowthan at the beginning of the 20th century.

Labour flows

Before World War I, individuals faced few policy re-strictions upon where they chose to travel and work andlevels of international migration were relatively high.However, in addition to linguistic and cultural difficul-ties, which continue to persist today for many migrants,the major barrier to international migration was that in-ternational travel was extremely expensive relative to or-dinary incomes.

The situation at the beginning of the 21st century is quitedifferent. Technological advances have dramatically re-duced the costs of international travel. Short-term busi-ness (and holiday) travellers in general face relativelylight restrictions in many countries. However, publicpolicy in many countries restricts the rights that individ-uals have to settle and work in a foreign country (2).Many EU countries welcomed economic immigrants inthe high-growth period that followed World War II, butthese policies were generally curtailed after the first oil

¥1∂ Within the EU, Member States first linked their currencies through theEuropean monetary system and ERM, and 12 Member States have nowpooled their monetary sovereignty by adopting the euro as their single cur-rency.

¥2∂ The EU guarantees free movement of labour between members, but EUMember States generally place strong restrictions on economic immigra-tion by third country (non-EEA) nationals.

25


price shock of 1973. The United States continues toadopt a more liberal approach to economic immigrationthan the EU, and is estimated to admit about 1 million

immigrants per year. Some EU countries have recentlytaken limited measures to encourage inward migration ofskilled workers.

26

C. The benefits of globalisation

How has globalisation affected human welfare? The sec-ond half of the 20th century, a period of increasing glo-bal economic integration, saw a six-fold increase inworld GDP (Figure 1) while the global populationincreased about two and a half times over the sameperiod (1). These numbers translate into major improve-ments in the welfare and quality of life of many of theworld’s citizens, and not just in the richest countries. Thepast 50 years have seen major improvements in humanlife expectancies, basic hygiene, vaccinations againstmany communicable diseases, and lower rates of infantmortality. The period also witnessed improvements indomestic governance in many countries and a more ro-bust set of international institutions and forums to dealwith global policy challenges than existed during previ-ous waves of globalisation.

Figure 7 shows the improvements that have beenachieved in life expectancies between 1970 and 1997.The bars, relating to the left-hand axis, depict life expect-ancy at birth in industrial, middle-, and low-incomecountries (2) in 1997. Although low- and middle-incomecountries continue to lag behind the industrial countries,the catch-up indicated by the percentage increase in lifeexpectancies since 1970, shown by the line relating tothe right-hand axis, is striking. In terms of numbers ofyears, low- and middle-income country citizens born in1997 could expect, on average, to live 10 years longerthan had they been born in 1970, whereas those born inindustrial countries in 1997 could expect to live fiveyears longer on average. These are major improvements,largely due to better hygiene and health standards, thatglobalisation has helped to spread (3).

Correlation is, of course, much easier to observe than cau-sation is to demonstrate and it is not simple to prove thatthe many benefits outlined above are also due to globalisa-tion. Nevertheless, research indicates that countries that areable to pursue policies of external openness to foreign tradeand capital, thus permitting the adoption of new technolo-gy and know-how, combined with respect for propertyrights and the rule of law domestically, have the bestchance of rapid economic development. It is unlikely thatany of these conditions is individually sufficient to delivereconomic development, yet one of the most powerful ob-servations in this debate is that there is not one example ofa country that has achieved sustained economic growth bypursuing import-substitution policies of high trade protec-tion (e.g. Masson, 2001). A reasonable degree of externalopenness would seem to be a necessary condition for sus-tained economic growth and continued poverty reduction.

Recent analysis from the World Bank identifies a group ofdeveloping countries — including China, India, Bangla-desh, Vietnam and Uganda — which have opened up theireconomies to trade and investment in the last 20 years.Figure 8 compares the growth performance of these ‘post-1980 globalisers’ with that of the rich countries and thosedeveloping countries that have not pursued internationaleconomic integration, the ‘non-globalisers’. The figureclearly shows the superior growth performance of the‘post-1980 globalisers’ since they changed their policies.Of course, not all of the newly globalising countries havechanged all of their international economic policies in fa-vour of greater liberalisation. However, the research pro-vides strong evidence of the beneficial effects upondeveloping countries’ growth prospects of policies of in-ternational economic integration.

¥1∂ IMF WEO (spring 2000).¥2∂ World Bank definitions.

¥3∂ The AIDS epidemic has seriously slowed improvements in life expectan-cies in those countries worst affected by it.

27


Figure 7: Life expectancy by country grouping in 1997 and increase on 1970

Source: Commission services, based on World Development Indicators and IMF (2000a).

Figure 8: GDP growth by country grouping (1960–2000)

Source: Commission services based on Dollar (2001).

0

10

20

30

40

50

60

70

80

90

Industrial Middle income Low income

Lif

e ex

pect

ancy

, yea

rs

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25

% in

crea

se, 1

970–

97

Life expectancy at birth (1997), in years % increase (1970–97)

0

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1960s 1970s 1980s 1990s

Ann

ual G

DP

gro

wth

rat

e (%

)

Rich countries Post-1980 globalisers Non-globalisers

28

D. Challenges facing the system

The major benefits that globalisation has brought tomany have not come without costs. Major policy chal-lenges remain to be tackled. These challenges includethe leverage that national governments have in a worldwhere competition may lead to a race to the bottom onsocial, environmental and other policies. A related issueis the provision of global public goods, which is seen asrequiring close cooperation among governments andsubstantial amounts of financing. In this study, the focusis limited to those challenges that are related to the inter-national financial and monetary system and to the issueof financing for development. In this context, three ma-jor concerns are related to trends in global income distri-bution, the increased volatility that may be associatedwith increased exposure to international trade and capitalflows, and abuses of an essentially open internationalsystem.

National governments in a globalised world

Concerns have been expressed that the nature of to-day’s liberal international financial system and the en-hanced international competition implied by globalmarket integration would increasingly curb the powerof national governments to set rules and standards ac-cording to domestic public preferences and needs.While internationally mobile capital and regulatorycompetition between countries can help to disciplinegovernments and enhance the efficiency of public insti-tutions, it is argued that the political pressures createdby the process of globalisation could place nationalgovernments in a regulatory race to the bottom thatreaches well beyond the sphere of financial markets.Although economists (1) neither find significant evi-dence for governments losing power nor of a race to thebottom in environmental policies, labour-market regu-lation or tax competition, the quality of labour and so-cial standards, consumer and environmental protection

are seen at risk (2). This concern raises a host of ques-tions, including the optimum level of decision-taking,i.e. national versus supranational. Summers (1999) ar-gues that a country that pursues greater international in-tegration and ensures appropriate domestic policies canno longer pursue many national policy goals independ-ently.

Global public goods

Some aspects of this perceived need for international multi-lateral collaboration in a globalising economy are highlight-ed in the concept of global public goods. Stability of theinternational financial and monetary system, an open trad-ing system or the protection of global environmental com-mons (e.g. climate, bio-diversity) are seen as goods that canonly be provided and maintained on the basis of internation-al cooperative behaviour and support. These goods as wellas other goals, such as communicable diseases control,knowledge, peace and security, can be interpreted as inter-national or global public goods (Box 1). Their provisiongenerates important externalities to the benefit of, in princi-ple, all people around the world regardless of their individ-ual contribution to the production of these goods. In theabsence of a supranational enforcement power, this createsan incentive for the individual, or the individual State, tofree-ride. As a result, investment in the provision of globalpublic goods tends to be suboptimal if the allocation deci-sion is left to markets alone. An efficient supply of thesegoods would thus require the development and implemen-tation of internationally accepted rules and standards aswell as adequate financing (3).

Trends in global income distribution

There has been a great deal of recent academic worklooking at the distribution and evolution of incomes

¥1∂ See CEPR (2001).¥2∂ Deutscher Bundestag (2001). ¥3∂ See for example Sandler (1997) and Kaul, Grunberg and Stern (1999).

29


Box 1: Global public goods

Public goods can be classified according to their spatial dimension in local (e.g. streetlights), national (e.g. nationaldefence), regional (e.g. environmental protection of in the Baltic Sea) and global public goods (e.g. the ozone layer). Aglobal public good is defined as a public good, the benefits of which accrue to essentially all geographical regions. Depend-ing on the type of public good, its benefits can accrue to present as well as to future generations. Examples of widelyaccepted global public goods include the protection of the global environment, communicable disease control, the fightagainst internationally organised crime and terrorism, international trade, international financial and monetary stability andinternational security. Others advocate adding elements that are considered key for the development process of low-income countries such as basic education, knowledge diffusion and public research. In contrast to private goods, a public good is characterised by two typical properties: (i) non-rivalry or non-congestion and(ii) non-excludability in consumption. Non-rivalry or non-congestion implies that a public good can be consumed (usedor enjoyed) by any individual without (significantly) diminishing the possibility of consumption for others. Non-excluda-bility means that it is either very costly or technically impossible to exclude non-payers from consuming the public good.In other words, the provision of public goods generates positive externalities for non-payers. Goods that feature bothattributes are referred to as pure public goods. Most public goods are impure and permit either some degree of selectiveexclusion of non-payers or incur some rivalry in consumption. National defence is regarded as a typical (national) publicgood as no resident can be excluded from nor do residents compete for its benefits. The opposite of a public good is a ‘pub-lic bad’, which is equally defined by non-rivalry and non-excludability. Examples of a public bad are communicable dis-eases, organised crime and pollution. The provision of a public good can often be considered in terms of reducing orremoving a public bad.

The provision of public goods constitutes a formidable policy challenge. As the allocation mechanism of the market is fail-ing, the optimum supply level of public goods is essentially determined by public choice. For pure public goods, the lackof rivalry makes it unlikely for market clearing prices to emerge, and the problems of excluding non-payers from consump-tion make it difficult to establish property rights. These properties also provide a systematic incentive for consumers tounderstate the true value of their marginal benefit of consuming the public good and encourage free-riding. As a conse-quence, the provision of pure public goods on the basis of (voluntary) individual contribution through private agents alonetends to be suboptimal.

In order to achieve socially desired levels, the public sector needs to support private contributions and/or provide adequateincentives to enhance voluntary private-sector contributions. At local and national level, governments support the provi-sion of public goods through taxes levied on its citizens. At global level, this collective action problem is compounded byseveral factors. Due to the lack of a supranational government, the provision of global public goods is the result of inter-national decision-making among sovereign States or entities and hence based on voluntary contributions from those States.Given the diversity of actors and depending on the nature of the global public good, the benefits and costs related to theprovision of global public goods as well as the ability to contribute to their provision are distributed asymmetrically acrosscountries and across generations. Although the benefits of global public goods essentially spread globally, there can besignificant differences in their visibility across countries, regions and over time. In some cases, such as curbing globalwarming, the bulk of the benefits will accrue to future generations, while the present generation bears the costs related tothe provision of the global public good today.

The type and magnitude of resources required to support the provision of global public goods depends essentially on thenature of the public good and the way it is produced. The World Bank (1) estimates that annually some USD 16 billion goto finance international public goods in developing countries around the world and complementary domestic infrastructurethat allows the absorption of these goods. These resources mainly support activities in health, environmental protection,knowledge creation and diffusion, and international peacekeeping. Instead of large-scale financing, the provision of public

(1) The World Bank, Global Development Finance (2001).

(Continued on the next page)

30



across the globe and at the impact that globalisation, andin particular more liberal trade, has had upon income dis-tribution. The literature stresses several important dis-tinctions. Global income inequality can occur due to amixture of income inequality between countries andwithin countries. It can occur because all are growing,but the rich are growing faster (absolute improvement,but relative worsening) or because the poor are gettingpoorer in absolute terms. In assessing whether or not glo-balisation has caused more or less income inequality, adistinction needs to be drawn between those countriesthat have pursued policies of increasing international in-tegration and those that have not. Further, it is importantto try to distinguish the effects of ‘globalisation policies’of increased openness that countries may or may nothave pursued from other simultaneous (domestic) policychanges that may also have affected income distribution.

Given differences in measurement methods and dataproblems, different authors emphasise different aspectsof trends in income inequality. Between 1900 and 2000,the world Gini coefficient rose from 0.40 to 0.48, imply-ing an increase in global income inequality over the pe-riod (IMF, 2000). Lindert and Williamson (2001), usingdata from Bourguignon and Morrisson (1999), reportthat between 1820 and 1992, global income inequalityrose and was almost entirely due to increased inequalitybetween countries, since within-country inequality hasshown no marked trend. However, the picture may havebegun to change in recent years. World Bank (2002) em-phasises the post-war convergence in real incomesamong developed countries and notes that the ‘post-1980globalisers’ have also begun to catch up with the richcountries (Figure 8), although there has been a simulta-neous increase in within-country inequality in a numberof countries. CEPR (2001) takes the view that global in-come inequality increased greatly during the 19th centu-ry, as some countries industrialised and others did not,continued to rise in the first half of the 20th century, buthas changed little during the past 50 years. In terms ofbroader measures of welfare, life expectancies haveincreased significantly over the past 50 years in many

developing countries, such that life expectancy conver-gence with the developed world has been much greaterthan income divergence.

However, extreme poverty continues to exist. The WorldBank estimates that the number of people living on lessthan USD 1 per day was roughly constant through the1990s at 1.2 billion. At regional level, East Asia and thePacific have made sustained progress in most areas,while South Asia and sub-Saharan Africa lag far behind.The impressive growth of East Asia and the Pacific is re-flected in the improvements in the ratio of its income tothat of high-income OECD countries, from around 1/10to nearly 1/5 over 1960–98. In sub-Saharan Africa, thesituation has worsened dramatically: per capita income,around 1/9 of that in high-income OECD countries in1960, deteriorated to around 1/18 by 1998. The share ofpeople living on less than USD 1 a day is as high as 46 %in sub-Saharan Africa and 40 % in South Asia, com-pared with 15 % in East Asia and the Pacific and LatinAmerica. In terms of growth, the performance of sub-Sa-haran Africa has been disastrous: between 1975 and1999 GDP per capita growth averaged – 1 %.

Economic theory suggests that liberalising trade shouldequalise factor incomes between countries, yet it is notclear that this is occurring (1). The recent work of theWorld Bank (2002) and Dollar and Kray (2001) arguesthat one must look at whether countries have embracedmarket opening ‘globalisation policies’. As noted above,‘post-1980 globalisers’ have achieved superior growthperformance compared to both rich countries and ‘non-globalising’ developing countries. In addition, the ‘glo-balisers’ did not, on average, experience higher incomeinequality. As a result, the poor shared in the benefits ofhigher per-capita GDP growth. However, some econo-mists have criticised the methodologies used in cross-

Box 1 (continued)

goods established on the basis of internationally agreed rules and regulations require the implementation of incentives forinternational cooperation and compliance. In some areas, such as international trade and the international financial andmonetary system, multilateral institutions are in place to provide for the global public good and to discourage non-coop-erative behaviour.

¥1∂ International labour migration is, in theory, a substitute for liberal tradepolicy that should also lead to more equal factor incomes, but, as shownabove, current globalisation is better characterised by freer trade than freerinternational migration.

31


country work of this nature (1), and others have noted thelack of good case studies in this area (2).

The Dollar and Kray work focuses on the globalisationpolicies of developing countries. However, this chapterhas noted that technological progress is a major drivingforce of globalisation. This process may well be increas-ing the premium available to skilled workers in all coun-tries. This may tend to increase inequality between theskilled and the unskilled within countries, including inrich countries. Globalisation may thus increase the needfor appropriate domestic policies to deal with the prob-lems faced by low-skilled workers.

Whilst the evidence on recent trends in income inequal-ity is not clear-cut, modern media technology means thatall are aware of the differences in standards of living be-tween rich and poor countries and regions. As such, it isa pressing policy issue. The effects of ‘globalisation poli-cies’ are probably too subtle to be categorised as simplygood or bad for income inequality. Globalisation is likelyto benefit substantially on aggregate those countries thatare able to participate in it, but it does create adjustmentcosts which may be concentrated on some segments of thepopulation, such as low-skilled workers in industrialisedcountries. The policy challenge is therefore to thinkthrough these complex interactions of policy and techno-logical change and to conceive of mechanisms that canhelp those that may lose from globalisation, whilst allow-ing countries to reap the aggregate benefits.

Increased exposure to volatility

Increased external economic integration as a result ofglobalisation brings with it increased exposure to inter-national economic events and thus economic shocks.Perhaps the most obvious manifestation of these shockscomes in the form of financial crises that have affectedboth rich and developing countries. In times of crisis,there is a tendency in financial markets for a ‘flight toquality’ of international capital, such as to the sovereigndebt of rich, stable economies. This can leave emergingmarket economies and developing countries withoutaccess to new short-term international capital or at pro-hibitive rates. More generally, internationally tradedcommodities and exchange rates may diverge sharplyfrom ‘fundamentals’ due to swings in market sentiment.

These swings may be particularly difficult for countrieswithout diversified production structures to accommo-date.

Price volatility is, of course, not only an internationalphenomenon. A diversified set of international buyersfor the output of an open economy may serve to limitprice fluctuations faced by domestic producers relativeto those that would prevail in a closed economy. Interna-tional economic integration may also bring access to in-ternational markets in insurance (e.g. futures markets)that smaller, closed domestic markets would not be ableto support.

In spite of this, recent financial shocks in developingcountries and emerging market economies have hadsignificant negative economic consequences (Masson,2001). In particular, actual or potential macroeconomicinstability may severely limit the extent to which pri-vate individuals are willing to engage in long-term in-vestment in an economy. The next chapter will discussin detail possible reforms to macroeconomic and finan-cial frameworks that could improve upon the currentsituation.

Abuses of the international financial system

There is increasing concern about the international fi-nancial system’s vulnerability to abuses (3). Character-ised by a high degree of openness and by the rapiddevelopment of new financing and payment tools, it hasbecome more difficult to control the international finan-cial system against abuses such as money laundering, thefinancing of criminal and terrorist activities, tax evasionand the circumvention of rules and standards. In somecases, corporate entities are deliberately established forsuch purposes.

Financial abuses can threaten the credibility and under-mine the integrity of the international financial system.Their consequences affect countries at every stage ofdevelopment and involve both onshore and offshore fi-nancial centres. The existence of abuses encourages ille-gal and criminal behaviour, including bribery andcorruption. Moreover, there is concern that harmful taxpractices could trigger reductions in tax revenues andlimit the ability of governments to provide for publicgoods at the socially desired levels.

¥1∂ Rodriguez and Rodrik (2001).¥2∂ Bhagwati and Srinivasan (1999). ¥3∂ See for example Group of Seven (2000b).

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Chapter II

The international financial systemin a globalised world

Introduction

The occurrence of financial crises in various parts of theworld in the last decade, and their impact on the econo-mies of the affected countries and their population’s liv-ing standards, has led to an intense debate about thecauses of this new wave of financial instability. Much ofthe focus of policy-makers has been on the soundness ofthe local financial sector, the consistencies in macroeco-nomic and structural reforms policies of the countriesconcerned and the appropriateness of their exchange-rate regime. In addition, however, the question has arisenwhether the international financial and monetary systemmore generally is still adequate to face the challenges ofour time, in particular the globalisation of business andfinance.

At a very general level, the international financial systemconsists of a set of principles, rules, decision-making

procedures and institutions structuring the relations be-tween States and private entities in financial area. It pro-vides the structure in which economic and financialactivity takes place. While sound policies at country lev-el are clearly central prerequisites, the main focus of thischapter will be on the role of an efficient international fi-nancial system for ensuring global financial stability.The chapter will first briefly characterise the evolutionof the international financial environment (Section A).Following a typology of the functions one could expectfrom a ‘first-best’ international financial system, adaptedto the existing conditions of a globalised world econo-my, it will then present an analysis of some of the chal-lenges that the current system poses to policy-makers(Section B). Section C will review proposals for dealingwith these problems and for improving the overall archi-tecture of the system.

35

A. Trends and achievements

Globalisation has changed many aspects of how people,organisations and businesses operate. It affects societiesand countries all over the planet in ways that are oftendifficult to predict. Perhaps more than in any other do-main of economic activity, globalisation has had pro-found repercussions on the financial sector and oninternational financial and monetary relations. As a re-sult, the rules, principles, and decision-making proce-dures that govern the system differ today quitesubstantially from those prevailing at the time of theBretton Woods agreements in 1944.

Trends that characterise the evolution of the internation-al financial system include the following.

• Deeper integration of international financialmarkets, where major assets are traded almostcontinuously by a wide number of operators. Inaddition to the large financial enterprises that areconnected to essentially all major financial centres,a growing number of increasingly diverse operatorsparticipate in international financial markets,including individual investors, pension and mutualfunds, industrial enterprises and hedge funds. Theemergence of this global financial marketplace owesmuch to the accelerating pace of technologicalprogress in the field of information and communica-tion technologies (ICT), which has resulted in theavailability of vast amounts of information (1), andin increasingly cheaper technical means to processit. This integration process is, however, far frombeing completed. Cross-border transactions remaingenerally more costly than domestic ones; regula-tions continue to differ across countries and marketparticipants do not share similar access to informa-tion and/or processing capabilities.

• Evolution of the role and function of exchange-rate regimes. The Bretton Woods system was basedon fixed but adjustable exchange rates to avoidexcessive volatility and to prevent competitivedevaluations while allowing for adjustment withinan international framework. Today, exchange ratesbetween the three major currencies fluctuate freely.Many industrial countries and emerging marketeconomies have opted either for hard pegs (such ascurrency board arrangements, dollarisation or a sin-gle currency) or for floating rates resulting in a ‘hol-lowing out of the centre of fixed but adjustablerates’ (2).

• Fuller liberalisation of capital markets. Thisagain contrasts with the features of the BrettonWoods system, where capital movements wereheavily restricted (and continued to be even in someindustrialised countries until the 1980s). Capitalcontrols have been dismantled in many countriesbecause they were viewed as significant barriers tofurther economic development. In addition, theywere increasingly perceived as ineffective instru-ments for maintaining exchange-rate stability and anindependent monetary policy. The pace of the drivetowards capital liberalisation has, however, sloweddown substantially following the emergence offinancial crises in the middle of the 1990s. It is nowwidely recognised that a strong domestic financialsector is a prerequisite for successful capital accountliberalisation, which itself should be properlysequenced. The debate on capital flow liberalisationis now, inter alia, focusing on the possibility ofintroducing temporary capital controls in a crisis sit-uation and on the use of capital controls on inflows(such as in Chile) as part of a banking and financialsystem strengthening effort (3).

¥1∂ See for example Hull and Tesar (2001).

¥2∂ For an in-depth discussion of the phenomenon, see Tavlas and Ulan(2002).

¥3∂ Eichengreen (1999).

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C h a p t e r I IT h e i n t e r n a t i o n a l f i n a n c i a l s y s t e m

i n a g l o b a l i s e d w o r l d

• The development of a large pool of savings in thedeveloped world in search of returns and risk diver-sification. Income growth, the ageing of populations,the development of pension and mutual funds and theliberalisation of capital movements in many parts ofthe world have been among the factors enticing cross-border investment. The availability of these large poolsof savings in search of returns and diversification isoften regarded as a two-edged sword (1). On the onehand, when global markets correctly price the risks andreturns associated with different investment opportuni-ties, cross-border capital flows promote an efficientallocation of global savings to its most productive uses.It also allows developing countries, which may havelow levels of saving, access to a larger pool of interna-tional capital. In particular, it allows developing coun-tries to complement their domestic savings, therebyenhancing their growth potential. On the other hand,cross-border capital flows are also highly sensitive torelative yields and risk developments and are thusprone to substantial swings. In addition, these fundscan exceed the ‘absorptive’ capacity of developingcountries and their financial system.

• A change in the level and composition of capitalflows to developing and emerging market econo-mies. Gross capital flows to these countries have risenconsiderably as a share of GDP since the early 1980s.At the same time, net private flows to these countriesthat hovered around 0.5 % of GDP during the 1970sand the beginning of the 1980s rose sharply to reach3 % of GDP in the mid-1990s but fell back to 1.5 % atthe end of the decade (2). Foreign direct investment(FDI) and equity flows have been playing an increas-ingly important role while syndicated bank lending andofficial assistance are declining. This phenomenon hasbeen particularly visible during the last decade. FDIflows have become the most important and stablesource of financing for these countries. This might beattributable, on the supply side, to the reduction ofrestrictions on cross-border equity investment andimprovement in communications that have reduced thecosts of acquiring information on assets abroad. On thedemand side, explanatory factors are the broadimprovements in the overall macroeconomic funda-mentals of developing countries, their opening tointernational capital flows and the wave of privatisa-

tions (3). However, these increased FDI and equityflows are heavily concentrated on a limited number ofcountries. The structure of external debt flows has alsochanged substantially with bonds substituting for adecline in bank lending.

• The development of a wider array of increasinglycomplex financial instruments. The rapid growth anddevelopment of new and more complex financialinstruments, such as over-the-counter (OTC) deriva-tives, has run in parallel with the emergence and devel-opment of internationally active financial institutions.These changes were made possible by spectacularadvances in ICT. These new instruments, by allowingfinancial risks to be better tailored to yield expectationsand risk preferences, have contributed to a more com-prehensive set of market instruments and haveimproved market liquidity and depth. However, theyrequire increasingly sophisticated management tools offinancial risk assessment which often use the samemathematical models and techniques. Also, ‘OTCderivatives activities can contribute to the build up ofvulnerabilities and to adverse market dynamics insome circumstances’ (4), as demonstrated by the 1998long-term capital management (LTCM) incident.

• The emergence of new international forums and thedevelopment of sets of multilateral and nationalrules, codes and standards. Besides the evolution ofthe existing institutions, the last decade has seen thecreation of a number of international forums and bod-ies and the establishment of new sets of standards, rulesand codes including data dissemination, fiscal, mone-tary and financial policy transparency, banking regula-tion and supervision, foreign exchange management,securities and insurance regulation, accounting, audit-ing, bankruptcy and corporate governance. This crea-tion of new forums and the establishment of new rulesruns in parallel with a deregulation process of the econ-omy characterised by a drive towards more flexibility(in labour, product and services markets) and the liber-alisation of trade and financial flows. It might also bethe result of the inadequacy of older rules to the work-ing of the present system and the need for new ones.Associated with this trend is a debate about the legiti-macy and efficiency of both existing bodies and newlycreated forums.

¥1∂ See for example Buch and Pierdzioch (2001).¥2∂ Mussa, op.cit.

¥3∂ Lane, Milesi-Ferretti, Gian Maria (2000).¥4∂ Schinasi (2000).

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B. Systemic issues

The characteristics of the current international financialmarketplace make it different and to a large extent morechallenging than the one prevailing up to the 1980s. Asa result, the ability of the international economic and fi-nancial system (that was built in the aftermath of WorldWar II and that was partly modified in the early seven-ties) to deal with current challenges has become the ob-ject of close scrutiny.

Any assessment of the performance of the present sys-tem is, explicitly or implicitly, based on views on themain functions that the international financial systemshould perform. These views are, by definition, norma-tive. For the purpose of this report, the following as-sumptions have been made about the functions,objectives and requirements that a first-best internationalsystem should fulfil.

• It should promote the international distributionof savings. It is in the interest of all countries that thelarge pool of worldwide savings, mostly originatingfrom developed countries, can be invested in thosecountries with more profitable investment opportu-nities. This includes developing countries, which areoften short of domestic capital, and offer highreturns on investment. A smooth flow of savingswould require an efficient payment, clearing and set-tlement system; solid financial institutions and mar-kets that are able to intermediate internationalsavings flows efficiently; recognised legal standardsand norms for international contracts; and well-developed information and communication infra-structures.

• It should support the adjustment of payments dis-equilibria. For a multitude of reasons, countries dosometimes face unsustainable debt levels and/orlarge payments imbalances that can lead to liquidityor solvency crises. In these circumstances, while theburden of adjustment must fall mostly on the coun-try itself, other countries have an interest in ensuring

that the international spillover effects of domesticadjustment are contained. Examples of this commoninterest include large depreciations of the exchangerate of a country, where tensions may arise betweenthe exchange-rate adjustment supporting the adjust-ment process and the impact of the depreciation onother countries’ trade and economic positions. Moregenerally, in a world of floating exchange rates,there can be instances of strong negative externali-ties if all countries follow strategies of competitivedevaluations. This requires the existence of policycoordination mechanisms to avoid the occurrence ofsuch a non-cooperative and suboptimal equilibrium.

The same holds for cases where a country follows aninconsistent macroeconomic policy that can lead toa rushed exit of foreign investors and precipitate anexternal payments crisis which can affect othercountries. Also, it is important for the internationalsystem to ensure that countries’ external debt and/ordeficits do not become too large and unsustainable.This calls for international support for domesticadjustment efforts, through international mecha-nisms of policy surveillance and dialogue, and,where justified, external financial assistance.

• It should help to promote financial stability, i.e.avoidance of excessive volatility and boom-bustfinancing cycles (1). Sound and sustainable domes-tic macroeconomic and financial policies are of pri-mary importance to ensure financial stability. Forcountries willing to attract international capital (be itin the form of portfolio investment, direct invest-ment in industrial or services businesses or throughthe issuance of international securities) it is impor-tant that investors have a clear understanding of thedirection of economic policy, the state of the econ-omy and the policy framework of the authorities.

¥1∂ Wyplosz (1998).

38



This would argue, inter alia, for international stand-ards and rules on issues such as transparency,accounting and disclosure of data.

• In times of financial stress, it should ensure mone-tary stability, meaning the provision of interna-tional liquidity when there are risks of a generalisedblockage of international financial relations becauseof the unwillingness or incapability of economicagents to conduct financial transactions or to take onfinancial risks. Given the deep interlinkagesbetween modern financial markets and financialinstitutions, a serious shock to the financial systemcan lead to the quick disappearance of liquidity. Pro-visions are then needed to prevent financial and eco-nomic crises (1). This may be seen as an example ofthe need for an international public good (2), whichis not provided necessarily by government in normaltimes but becomes necessary in time of crisis.Recent years have seen at least two occurrences ofsuch severe financial shocks. In the case of the fail-ure of LTCM, no lender of last resort interventionwas needed but the US central bank did intervene toassemble a coalition of domestic and foreign finan-cial institutions to come to the rescue of the failedinstitutions, highlighting the need for internationalliquidity support. Second, in the wake of the 11 Sep-tember attacks against the United States, the needfor international liquidity was met by swap arrange-ments between the Federal Reserve Bank of theUnited States and the European Central Bank (3).

• It should have an efficient governance frame-work. The abovementioned functions of the interna-tional financial system may require common bodiesand institutions, mechanisms of cooperation andcoordination and — where required — mechanismsthat support and set penalties for the implementa-tion, or lack thereof, of the commonly agreed rules.Such a framework will raise questions of efficiencyand legitimacy.

Overall, the system has functioned well in channellingsavings into productive investment and fostering pros-

perity and productivity growth in both developing anddeveloped economies. Market discipline has generated agrowing consensus regarding the merits of stability-ori-ented macroeconomic policies. Broad and deep marketsare seen as key for the efficient pricing and managementof risks, which in turn is looked at as a necessary condi-tion to expand the range of financing opportunities at thedisposal of actors, including in developing countries,many of which would otherwise be perceived as toorisky by individual investors. Moreover, internationalcompetition in the financial sector has helped to reducefinancing costs, rendering the intermediation of savingsto investment more efficient and disciplining economicpolicies.

Nevertheless, recent experiences have brought to thefore a number of real or potential systemic weaknesses.The recurrence of financial crises in recent years hassuggested that the system is not fully adequate any moreto cope with the changed environment. In addition, it hasbeen seen as allowing abuses in terms of money launder-ing, financing of illegal activities and tax evasion, andhas segments that are largely unregulated.

B.1. International monetary stability

Although the integration of financial markets and the in-stitutional and regulatory framework in which they oper-ate have spurred economic growth, the internationalmonetary and financial system has continued to be criti-cised for being crisis-prone. With the exception of theERM crisis of 1993, the crises of the 1990s have mainlyaffected developing countries and, for most of them,have had important consequences in terms of output loss,welfare, social conditions and unemployment. Whilethere have been other historical periods when crises oc-curred at a relatively high frequency, in particular in thelate 19th century and the 1920s and 1930s, the nature andsystemic impact of crises in recent years has become acause for concern.

Key features of the crises and of the environment inwhich they took place include the following.

An increased frequency and intensity. Compared tothe Bretton Woods period, the frequency of crises post1973 has doubled Bordo (2000). Crises have continuedin the 1990s, including Mexico (1994), East Asia (1997–98) and Russia (1998). Turkey (2001) and Argentina(2001) are the most recent examples. While it is oftenclaimed that in addition to becoming more frequent,

¥1∂ Or an international financial crisis manager, as per Rogoff(1999).

¥2∂ Kindleberger (1988). ¥3∂ Indeed, as argued by Rogoff (1999), page 22, there is no need for

a new global institution to provide such liquidity. Cooperationamong the key central banks is however crucial.

39


modern crises have become more damaging, Bordo(2000) does not find evidence that recent crises havegrown longer or output losses have become larger.

The multiplication of actors involved. Compared tothe debt crises of the 1980s, the current wave of financialcrises are more difficult to deal with given the domi-nance of market-based financing, which involve a largenumber and variety of investors. When bank and officiallending dominated international financing, the numberof actors involved was much lower and it was easier toreach a cooperative solution. In the absence of a clearframework of crisis resolution, there is in addition an is-sue of moral hazard that has been linked to the provisionof large international financial rescue packages to coun-tries affected by capital flight.

The increased risk of crises becoming contagious andself-fulfilling. Contagion is not a new phenomenon; inthe past, financial crises have often spread across coun-tries. However, under the Bretton Woods regime of low-capital mobility and limited linkages among key finan-cial markets, contagion was less pervasive. On the con-trary, recent years have seen a new wave of contagioncrises, where countries that had relatively sound eco-nomic fundamentals were subject to speculative attacks.Contagion happens when market participants, because ofdevelopments in other countries, consider that economicfundamentals in a country have to be fundamentally re-assessed and that the price of its financial assets have be-come overvalued. Contagion has been most evident inthe ERM crisis of 1992/93, in Asia in 1997 and in LatinAmerica in 2001. Contagion has also been exacerbatedby financial market participants’ tendency towards herdbehaviour, i.e. the preference to follow the market’s di-rections in order to minimise the risks associated withmore extreme positions. The advances in informationtechnology and risk-management techniques, whichhave been adopted by most of the financial industry andoften rely on similar models of risk evaluation and man-agement, have reinforced the scope for this type of be-haviour.

In addition, if market participants become convincedthat there is some underlying factor justifying the possi-bility of a crisis, a crisis can become self-fulfilling. Forexample, foreign investors may sell the financial assetsof a country that seems in good condition because thiscountry is affected by a similar economic shock, it sharessimilar structural conditions (financial sector structure,debt levels) or it belongs to the same class of assets as an

affected country. It is usually impossible to anticipate inadvance which macroeconomic element or structuralcondition the markets will focus on to justify their expec-tation of a crisis, since almost all countries have econom-ic weaknesses in some form or another.

Lastly, it has been claimed that the globalisation of fi-nancial markets has led to the faster transmission of eco-nomic and financial disturbances more generally with, inaddition to the trade channel as a transmission mecha-nism, a greater synchronisation of business cycles acrossthe world (IMF WEO, autumn 2001). Moreover, flexibleexchange-rate systems have only partly succeeded in in-sulating economies from international disturbances.

The increasing scope for information asymmetries.Information asymmetries mean that participants in a fi-nancial transaction do not have the same quality of infor-mation to evaluate the prospects of the transactionsbeing carried out successfully. Typically, for example, aborrower has more information on his financial perspec-tives than the lender. With the globalisation of markets,the multiplication and diversity of investors involved ininternational financial transactions, the dominance ofmarket-based finance relative to the more traditionalbank financing, and the vast amount of information to beprocessed, information asymmetries have become morepervasive.

Pervasive information asymmetries have had two broadtypes of concrete consequences in the international fi-nancial area in recent years (1). First, they tend to lead tocredit rationing when lenders believe that they do nothave the proper information to evaluate properly theriskiness of a proposed financial transaction. This maylead for example to a situation whereby good corporaterisks in developing countries cannot access external fi-nancing directly because lenders do not possess enoughinformation about the country, the company and its busi-ness. Second, and conversely, information asymmetrieshave led to boom cycles of capital towards some types offinancial assets, for example, emerging market bonds orshares of telecommunications companies, as investorsonly focused on the positive information.

The increased size and volatility of private-capitalflows towards developing countries. Following the twooil shocks, developing countries attracted record

¥1∂ See for example Devenow and Welch (1996).

40



amounts of foreign capital, mostly in the form of tradi-tional bank loans (syndicated or not). The prospects ofdefault by Mexico and Argentina in the early 1980s pre-cipitated the end of this cycle of large capital inflows. Inthe early 1990s, however, following the liberalisation oftheir capital accounts, a new cycle of private-capital flowto developing countries began, but was stopped and re-versed towards the middle of the decade in the wake ofthe Asian crisis.

A characteristic of this more recent reliance on externalfinancing has been that a number of countries have takenon large debt-creating inflows with short-term maturi-ties. Because they are often unable to borrow locally andwith long-term maturities, it is tempting for developingcountries’ governments and enterprises to borrow on in-ternational markets. Most of the borrowing takes place inforeign currencies (because of lower interest rates andeasier availability than when borrowing on the localmarket in the domestic currency) and at relatively short-term maturities (reflecting foreign lenders’ preferencefor reducing their risks).

Foreign borrowing is particularly attractive under fixedexchange rates. However, if foreign investors decide towithdraw capital en masse, the economy is presentedwith a two-faced crisis. The first one is a traditional li-quidity crisis; current financial resources are insufficientin the face of short-term maturing bonds and refinancingbecomes difficult, if not impossible. In addition, becauseof the currency and maturity mismatches in the balancesheets of local banks and enterprises resulting from bor-rowing short term in foreign currency, the liquidity crisiscan very rapidly translate into a solvency crisis. If a de-valuation results and under the new macroeconomicconditions, the expected cash flows generated by the op-erations of local banks and companies are not adequateto meet their financial obligations.

B.2. Abuses of the global financial system

The global financial system has increasingly been usedto ‘launder’ revenues generated by illegal activities, suchas drugs-related crime, and to channel funds to peopleand organisations involved in illegal activities, such asterrorism. The increasing ease of transferring fundsacross borders, the very extensive networks of all mainbanks (through their correspondents) and the growingnumber of countries that have opened their capital ac-count imply that it has become more difficult to controlthe origin and the ultimate destination of funds entering

the global financial system. Moreover, it has become in-creasingly clear that corporate vehicles are being used inmoney laundering and tax evasion schemes, organisedcriminal activity, and as a way to circumvent regulationsand manipulate equity markets.

There are no estimates of the amount of money that is be-ing processed in the international financial system to fi-nance terrorist activities. With respect to moneylaundering, the IMF is quoted as estimating the aggre-gate size of money laundering in the world as being be-tween 2 and 5 % of global GDP, or roughly USD 600 toUSD 1 500 billion (1).

The abuse problem has been compounded by a number ofcountries and jurisdictions that have built their competi-tive advantage through very favourable tax and regulatoryenvironments for non-residents funds, while at the sametime limiting their cooperation with the judicial, tax andpolice authorities of other countries. In addition to provid-ing an accommodating environment for money launder-ing and other crime-related financial activities, thesejurisdictions undermine the ability of other governmentsto finance essential public goods and services by provid-ing easy opportunities for tax evasion by non-residents.As a result, decisions on where to locate economic activi-ties are distorted and the tax burden in the affected coun-tries is shifted towards law-abiding taxpayers.

There are few estimates of the size of financial flows tofinancial and tax havens, and the available figures do notdistinguish legitimate investments from investments re-sulting from the harmful features of these jurisdictions.However, they clearly highlight the growing importanceof financial flows to these jurisdictions while showing thepeculiarities of these flows. Hines and Rice (1994) notethat tax havens account for only 1.2 % of world popula-tion and 3 % of world GDP, but they attract 26 % of as-sets and 31 % of profits of American multinationals (2).According to the OECD, foreign direct investment bycompanies in G7 countries in a number of low-tax juris-dictions in the Caribbean and in South Pacific islandStates increased more than five-fold over the period1985–94, to more than USD 200 billion, a rate of increasewell in excess of the growth of total outbound foreign di-rect investment (3).

¥1∂ See http://www1.oecd.org/fatf/.¥2∂ Hines and Rice (1994).¥3∂ OECD (1998).

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In addition to the concerns associated with the misuse ofthe financial system, there are other worries that are relat-ed to the intensified linkages between markets, intermedi-aries and infrastructure and which may become sources ofrisk to systemic stability and hence to the economic stabil-ity of countries that participate in the international finan-cial system. These worries relate to the growing use ofsophisticated financial management techniques, a greaterreliance on in-house procedures for risk assessment and,in particular, the regular recourse to leverage as a meansto magnify potential gains on investment positions.

Highly leveraged institutions — mainly hedge funds —play an important role in the international financial sys-tem by facilitating the efficient sharing of investor risk.However, the activities of hedge funds are often charac-terised by highly speculative behaviour. This behaviourof hedge funds, which are typically constructed so as toavoid regulation, has long been a source of concern topolicy-makers. The background to the most recent bout

of concern about highly leveraged institutions was thedestabilising effects of the long-term credit managementcrisis in the autumn of 1998 and the earlier crises inSouth-East Asia and Russia.

The abuses, misuses and lack of regulation of the globalfinancial system have been made easier because of theslow and difficult cooperation among cross-border judi-cial, tax and policy authorities. It should, however, benoted that the events of 11 September have significantlychanged the position of some policy-makers, in particu-lar the US administration with regard to their assessmentof the costs (in terms of compliance costs for financialinstitutions) and benefits (in terms of preventing illegalactivity) of greater international oversight on financialflows as well as pressure on non-cooperative countrieswhere practices have been adjudged to favour illegal fi-nancial activity. As the next section will show, there areincreased efforts being made at international level to ad-dress these challenges.

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C. Towards a more stable and better functioning international monetary and financial system

Recent years have seen the emergence of numerous pro-posals on how best to adapt the international financialand monetary system (IFMS) to the changes and chal-lenges of a global economy. While this reform drive wasaccelerated by — and became more public with — thefrequency of financial crises in the 1990s, it is not a newphenomenon. Previous decades had seen other proposalsto reform and adapt the IFMS to the evolution of eco-nomic and financial relations and to changes in relativeeconomic and political powers. Examples include thecreation of the WTO, which was preceded by the GATTbut which became a fully-fledged international organisa-tion only in the mid-1990s (1). Others, even highly pub-licised ones, have had rather limited effects: already in1974, the UN General Assembly adopted the declarationand the action plan for a new world economic order.

This section on proposals for reforming the system limitsitself to the current policy debate and to the main propos-als. It provides a short analysis of the pros and cons ofthese proposals, their political and practical feasibility aswell as an assessment of the necessary conditions forsuccess.

For the purpose of this report, the reform proposals havebeen grouped into four categories: modalities of crisisprevention and management (C.1), initiatives to reducethe abuses of the international financial system (C.2), re-gional and global cooperation (C.3), and reform of theinstitutional framework (C.4). These broad categoriesaddress to some extent the perceived failures in theworking of the IFMS that were developed in the previouschapter.

C.1. Modalities of crisis prevention and management

In the wake of the financial crises of Mexico in 1994/95and in South-East Asia in 1997/98, a discussion re-emerged about the instability of the IFMS and its prone-ness to financial crises. The financial crises were seen toexpose significant problems in the functioning of inter-national financial markets and of the system governingthem. These problems included the following.

• Most participants (the IMF, like most other interna-tional institutions, major policy-makers and creditrating agencies and private investors) were taken bysurprise.

• Capital inflows had been mismanaged by emergingmarket economies, with excessive short-termindebtedness provoking a rush for the exit by inves-tors, thereby accentuating the severity of the crisis.

• Private creditors were perceived to have takenexcessive risks, a fact which was attributed to defi-ciencies in information provision and processing butalso to the creation of expectations about an officialbail-out (either by the debtor country or the interna-tional community) — the ‘moral hazard problem’.

• IMF-led assistance packages were perceived to beboth huge from an historical perspective and in rela-tion to the financial resources of the Fund and ‘toolimited’ to contain panic and prevent very severefall-outs in crisis countries.

• There was a sentiment that whereas gains from riskyinvestments — that contributed to the crises — were¥1∂ See for example Gardner (1980).

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accrued by the private sector, the official community(i.e. ultimately the taxpayer) had to pick up the billwhen investments turned sour. While this was nottrue across-the-board (equity holders suffered hugelosses in many crisis countries), the concern wasvalid with respect to short-term creditors, who hadto a significant extent been able to limit their losses.

Against this background, calls were made to adapt the setof rules and practices governing the IFMS, and the roleof the International Monetary Fund in it, to the challeng-es of free and large capital flows. These calls for reformwere not only made by academics, journalists, or civilsociety but also came from the G7, other governmentsand indeed from the Fund itself.

Some of the proposals to make the international mone-tary and financial system less prone to crises are listedbelow, separating probably somewhat artificially theones pertaining to crisis prevention from the ones relatedto crisis resolution. Some initiatives are in the process ofbeing implemented reflecting a high degree of consensusof the international financial community; others lack atpresent sufficient political support or would imply toohigh a level of public intrusion in the markets. Whereasmost of the proposed changes are being dealt with in theexisting framework, some of the more ambitious ones re-quire the creation of a new institution or a much moreprofound reform of the architecture.

C.1.1. Crisis prevention

At crisis-prevention level, i.e. ex ante measures to im-prove market participants’ risk assessment, strengthenmarket discipline and thereby minimise the risk of crises,much has been achieved but some suggestions for fur-ther action and progress have been made.

• There is general recognition that pursuit of soundpolicies and the existence of a sound macroeco-nomic and structural framework remains the majorand essential condition for reducing the occurrenceof financial crises. Sound policies require a continu-ous effort to which the IMF, through its surveillance,and private-market participants, through the feed-back they give to authorities, can contribute. Soundpolicies are, however, not always sufficient sincefinancial market participants may fail to differenti-ate sufficiently between good performers and badones, are sometimes prone to herd behaviour or needsometimes to withdraw their funds from sound

investments to meet margin calls in othermarkets (1).

• Many efforts have been devoted to improving theflow of information to market participants. Initia-tives were taken in order to obtain better quality andmore timely information from countries (such as theIMF special data dissemination standard (SDDS)and general data-dissemination system (GDDS),and the data-quality reference sites (DQRS) (2), atimproving information disclosure by policy-makersto markets (such as public information notices(PINs), publication of letters of intent and Article IV‘Staff reports, fiscal, monetary and financial trans-parency codes’) and at getting feedback from mar-kets through the organisation of a more permanentdialogue between the IMF and market participants.This drive towards better information is alsoreflected in the progress with respect to informationprocessing by the IMF itself through improved Fundsurveillance and the development of early warning,or vulnerability, indicator systems.

However, this approach also has its limits. Perfectinformation is an illusion. The existence of informa-tion asymmetries in capital markets is a well knownfact of financial life since a borrower, whatever thestandards and his willingness to respect them, willalways be better informed about his situation thanhis creditors. Standards can also sometimes induceperverse behaviour by creating a false sense of con-fidence and/or introducing a bias towards some typeof capital flows or in favour of some specific coun-tries without proper risk assessment. Moreover,standards and codes are not value-less and majorpolitical differences continue to exist about whatthey should cover, how normative they should beand how they should be implemented and/orenforced. Also, since the need for information on theeconomic situation and policies of a country

¥1∂ For a more in-depth discussion of capital market dynamics inboth mature and emerging markets, see for example the biyearlyIMF publication ‘International capital markets, developments,prospects and policy issues’ and in particular the September 1998issue.

¥2∂ The SDDS was established in 1996 to guide countries that have,or that might seek, access to international capital markets in thedissemination of economic and financial data to the public. Andthe GDDS was established in 1997 to guide countries in the pro-vision to the public of comprehensive, timely, accessible, andreliable economic, financial, and socio-demographic data.

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depends, to some extent, on its access to financialmarkets and levels of development, an appropriatebalance needs to be found between the voluntary orcompulsory character of standards. Finally, effortshave so far concentrated on information to the mar-kets, while it has been suggested that creditors couldalso be more transparent by releasing information onthe composition of their asset portfolios.

• Efforts to make countries less vulnerable to criseshave also been geared at developing deeper andmore liquid financial markets and at strengthen-ing domestic financial systems. These efforts havebeen made by, or are underway in, not only emerg-ing market economies but also in advanced coun-tries since many of them experienced during therecent past or are experiencing (Japan) more or lessacute forms of banking or financial crises (1). How-ever, as recently demonstrated (2), banking crisestend to have a bigger negative impact, in GDP terms,in emerging market economies than in advancedcountries because the former tend to rely more onbank financing in light of their level of economicand institutional development. Banking crises,because they tend to spread to the whole financialsector and to the whole economy, have generallymuch more acute (direct and indirect) costs for theeconomy than stock or bond price variations (3).

Strengthening prudential regulation and supervisionare among the most important micro-prudentialtools to foster financial stability and to preventfinancial crises. Worldwide, supervisory efforts arecurrently directed at developing a sharper focus onthe risks within a financial institution. G10 coun-tries, under the auspices of the Bank of InternationalSettlements, have reinforced their role in preparingregulatory recommendations in the banking fieldthat will set capital adequacy standards for the inter-national community at large. Work is also underwayon the convergence of supervisory practices.

These efforts are complemented by the extension ofIMF surveillance to domestic banking and financialsystems through financial sector assessment pro-gramme (FSAP) and financial system stability

assessments (FSSA). These exercises aim at identi-fying ex-ante the strengths and vulnerabilities of acountry’s financial system and how to address them.Increasing the governance and regulation of finan-cial institutions in developing countries and emerg-ing market economies is another priority, which runsin parallel with these IMF efforts.

In addition, some policy-makers argue that thedevelopment of a securities market should become apriority for emerging market economies (4). Deepand liquid securities and bond markets, however,require a legal and institutional framework (includ-ing disclosure requirements, contract enforcement,market rules and corporate governance) that takestime and costs to develop.

• In the framework of the G20, it has been argued thatthe strengthening of the country’s foreignexchange reserves should become a priority foremerging market economies’ policy-makers. In thatview, emerging market economies need a sufficientbuffer of foreign exchange reserves relative to theirdebt (short-term debt generally) in order to re-assuremarket participants about their ability to servicetheir debt. While there is agreement that adequateforeign reserves are obviously confidence enhanc-ing, it is difficult to determine a single level thatwould, irrespective of circumstances, provide insur-ance against market attacks. Moreover, holdingexcessive reserves can be costly for the central bankand the economy.

Progress is also being made on the following fronts butat a slower pace because these proposals are either of aless consensual nature or more difficult to implement inpractice.

• The IMF is stepping up its efforts to develop anearly warning system (5) but also to stimulateemerging market economies’ policy-makers to clar-ify, during Article IV consultations, their possiblepolicy responses to crises. While this approach hasthe advantage of increasing the preparedness of theIMF and debtor countries to potential crises, eco-nomic and political circumstances evolve rapidlyand the intrinsic element of a crisis is surprise.

¥1∂ Several European countries were hit by financial crises in thebeginning the 1990s, notably Sweden, Finland and Norway(Bank of Finland 2001).

¥2∂ For instance in Goldstein (1998).¥3∂ See IMF (1998).

¥4∂ See for instance Tsang (1998).¥5∂ See Köhler (2001).

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Moreover, care needs to be taken to avoid that anIMF assessment would itself precipitate a crisis.

• Though there seems to be a wide consensus on thetheoretical merits of including collective actionclauses (CAC) (majority action clauses, sharingclauses and representation arrangements) into newinternational bond issues of emerging market econ-omies, implementation has been rather limited.CACs are expected to facilitate the inclusion ofinternational bonds into comprehensive debt-restructuring operations, and to improve the pricingof risks by bondholders. Some, however, fear thatthe inclusion of such clauses will increase thefinancing cost to emerging market economies.Industrialised countries also differ on the idea of‘leading by example’ by introducing these clauses intheir own international bond issues. Progress onCAC clearly necessitates a ‘critical mass’ of coun-tries to move forward.

• The idea of creating clubs of creditors is alsoappealing (1). Such clubs would bring together allcreditors of sovereign debtors and would allow todisseminate information among them on the situa-tion of the debtor country so that they could collec-tively adopt more rapidly and efficiently the bestsolution in case of crisis. It would be preferable toestablish them prior to crises and they could usefullycomplement CAC. These clubs would play a rolesimilar to the ones of bank advisory committees inthe 1980s or the so-called London clubs in the firstpart of the century. Private-market participants haveso far been reluctant in organising themselves insuch a way because they fear that by doing so theywould implicitly facilitate default by sovereigndebtors. Without international official financialcommunity lobbying, there is little chance that theywould take the initiative.

• There is also a wide agreement that emerging marketeconomies should develop and/or broaden the use offinancing instruments that can be used as a first lineof defence in case of crisis. Such instruments includeprivate contingent credit lines (as already establishede.g. by Argentina and Mexico) and call options in

inter-bank loan contracts that would enable debtors to‘lock in’ loans in the event of a crisis. As such, theyreinforce official foreign exchange reserves, allow abetter pricing of risk by market participants and ena-ble debtors to hedge against their risks more effi-ciently. They are, however, quite costly and difficultto operate in practice since the ‘trigger event’ shouldneither create self-fulfilling crises nor moral hazard.Moreover, recent experience such as in Argentina hasshown that calling on these credit lines might cause afull risk re-assessment by private creditors therebyprovoking capital outflows and/or the evaporation ofother sources of capital inflows.

• Though the principle of free international flowsremains solidly anchored in the IMFS and is consid-ered to be a final objective for all countries, capitalaccount liberalisation has been heavily discussed.International private-capital flows have become themajor source of finance and investment for essen-tially all emerging market economies. This processwill probably extend itself to developing countries,perhaps with the exception of the poorest ones. Themerits of opening up to capital inflows are widelyacknowledged. However, while countries should beencouraged to open their capital markets, it is neces-sary to ensure that this take place within an orderlyand well-sequenced process. Whether and to whatdegree multilateral institutions should promote thisprocess or even be given jurisdiction over capitalmovements remains an issue for discussion.

There is widespread consensus that capital accountliberalisation needs to be orderly and well-sequenced, starting preferably at the long end(including with FDI) and that the process should beconsistent with the overall stability of the economyand, in particular, the soundness of its financial sys-tem. At the same time, one needs also to recognisethe distortional effects of capital controls and thetendency to see their effectiveness erode over time.This provides an incentive to liberalise further thecapital account.

The role of the international community in the capitalaccount liberalisation process has not been fully set-tled. The Asian crisis, which was widely perceived aslinked to inappropriately sequenced capital accountliberalisation, has reduced support for proposals toamend the IMF articles of agreement to make capitalaccount liberalisation one of the purposes of the Fund.Such an amendment would not only provide an

¥1∂ See for example Eichengreen et al (1995a) and Eichengreen(1999). Some countries, such as Brazil unsuccessfully tried thisapproach.

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explicit legal base for the inclusion of capital accountissues into Fund surveillance, which is taking placeanyway, but would also enable the Fund to includecapital account liberalisation into programme condi-tionality and give the Fund jurisdiction over capitalmovements. The latter option would establish an obli-gation for members to liberalise them, which wouldbroadly mirror the Fund’s competence with regard tocurrent account transactions.

• Within that debate of capital account liberalisation,the question of taxes on capital inflows hasreceived renewed attention. These taxes can take theform, as in Chile, of non-remunerated deposits forcapital inflows but could also proceed as taxes orquantitative ceilings on short-term foreign financialflows. They can, as shown by various studies (1),encourage longer term financing from internationalinvestors and thus discourage more volatile capitalinflows. It is argued, however, that they need to bebroad-based to avoid creating loopholes; temporarysince their persistence would encourage tax evasion;and complemented by measures to strengthen thefinancial system.

Finally, a number of proposals have yet to gather suffi-cient support.

• Soros proposed in the midst of the 1997–98 crisis ofemerging markets the creation of an internationaldebt insurance agency scheme that would befinanced by a fee paid by borrowing countries (2). Themechanism would operate on the basis of a country-specific ceiling on international borrowing that wouldbe assessed by the IMF in light of the country’s finan-cial and economic situation. This mechanism wouldrequire that the IMF would only be prepared to pro-vide assistance to countries respecting the ceiling. Ifdebtor countries were to borrow in excess of the ceil-ing, markets would be expected to request a higherrisk premium to cover default.

The advantages of this proposal are a better pricingof risk (if the ceilings are assessed correctly); theavoidance of a rush to exit in countries respectingthe ceiling; and the implicit rejection of bailouts forcountries disregarding the ceiling. However, it isquite difficult to set an economically sound ceiling,

independent of changing economic and political cir-cumstances and based on economic considerationsonly. Moreover, a few large international borrowershave already borrowed in excess of what could bereasonably considered as an economically soundceiling and would thus not qualify. There are alsodoubts about the actual relevance of differentiatingdomestic/international borrowing and private/publicdebt and about whether the IMF (and the interna-tional financial community) would be in a positionto refrain from intervening in support of countriesdisregarding the ceiling, particularly the systemicones. The cost of borrowing for all emerging marketeconomies (insurance fee and risk premium forunsinsured) would increase.

• The creation of an international prudential supervi-sory agency has recently been proposed as a way toaddress the dichotomy between national supervisionand globally operating financial institutions (3). Asfinancial markets become more integrated, new rulesare being developed within various forums such as theBIS, the FSF, the IMF/WB, the FATF and the OECD.These rules, codes of conduct, and standards to beimplemented rely most of the time on the goodwill ofcountries. Under the proposal, they could be madecompulsory and would be monitored by the interna-tional agency. This would have the advantage of mak-ing the rules more explicit, ensuring a level playingfield, thereby possibly increasing information about thehealth of internationally active financial institutions. Incase of crisis, coordination will be facilitated and therisk of contagion would diminish. The idea, however,requires a high degree of global political consensussince questions about the legal and enforcementpowers of this international agency over financial insti-tutions, national supervisors and central bankers wouldhave to be settled.

C.1.2. Crisis resolution

At crisis-resolution level, progress has been more limited.The balancing exercise between adjustment by the debtorcountry, official financing, and private financing has be-come more complex than 20 years ago. Financial marketshave grown more rapidly than the financial resources atthe disposal of the Fund and the reserve assets of creditorcountries. Capital market participants are more diverseand numerous and reaching a cooperative solution among

¥1∂ Eichengreen and Mussa (1998).¥2∂ Soros (1998). ¥3∂ Kaufman, Henry (1998).

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them and the debtor country is much more arduous. More-over, whereas sovereign borrowing used to dominateemerging market country financing, borrowers are nowpublic institutions, financial companies and corporateentities, which sometimes benefit from an implicit or ex-plicit public guarantee. Finally, most capital account re-strictions have been removed, facilitating the use ofofficial assistance money for capital outflows.

The question also arises whether, and to what extent, thebalance should be tailored to specific country circum-stances. While it has been claimed that the wide and vary-ing number of actors, both on the debtor and creditor side,increases the need for a common framework for crisis res-olution in order to ensure some fairness, some of the re-form proposals acknowledge, sometimes explicitly (1),that ‘systemic’ countries — those that could trigger conta-gion or are politically most important — need to be treateddifferently. Such a case-by-case approach to crisis resolu-tion, however, gives the main IMF shareholder an advan-tage in influencing the terms of each rescue operation.

The IMF is currently engaged in a process of reviewingthe conditionality attached to its financing. There isbroad agreement that conditionality needs to focus onthose policies that are critical to achieving the macroeco-nomic objectives of the programme (2). The question ofhow to associate the private sector in the resolution ofcrises has also received a lot of attention. Related to thisdiscussion, proposals have also been formulated for amore radical change in the role of the IMF in handlingcountry crises.

• There is a consensus, at least on paper, on the needto further develop the principles for private-sec-tor involvement, that were laid down in the IMFCPrague framework to involve the private sector inboth the prevention and the resolution of financialcrises. The objective is to provide clearer guidancefor market participants, debtor countries and theofficial creditors. The key principles of the frame-work include:

— the commitment to honour contracts wheneverpossible;

— equitable burden sharing between the public andprivate sectors;

— comparable treatment of different classes ofcreditors;

— main responsibility for restructuring with debtorcountries;

— assessment of the need for PSI on the basis of (a)the country’s medium-term payment capacityand (b) its chances of regaining market accessquickly. Depending on the situation, the pro-gramme could then either (1) rely on the catalyticcapacity of the Fund, without PSI, (2) call for vol-untary and temporary arrangements to overcomeproblems of creditor coordination or (3) involvean actual debt restructuring or reduction.

However, this framework is work in progress and needs tobe further operationalised.

• The international community has until now failed todevise a clearer and more solid legal framework forstandstill, debt restructuring, and debt reduction,in case a country cannot secure adequate voluntaryparticipation in crisis resolution from its private credi-tors. Under a standstill, a country would be allowed tosuspend temporarily payments on some, or all, of itsexternal obligations. This would force market partici-pants to reconsider and could reduce herd behaviour.

The option of a standstill could be made more cred-ible if IMF access limits were applied more strictly.Market participants would realise that huge bailoutpackages by the Fund would become unlikely andthat, unless a voluntary agreement is reached, astandstill would be possible.

A standstill could also gain acceptance if accompa-nied by an extension of the Fund’s policy of lendinginto arrears for bonded debt. This policy initiated inthe 1980s for commercial bank debt allows the IMFto provide financial support to a country which is inarrears but is negotiating in good faith with its cred-itors. By doing so, the Fund encourages a positiveoutcome from discussions between the debtor coun-try and its creditors. However, such a policy forbonded debt could trigger lawsuits by creditors withthe objective to attach the IMF money, a risk lesspresent with commercial banks that can be subject toofficial moral suasion.

The Fund could also consider backing a standstill bymaking use of Article VI of its articles of agreement,which allows the institution to request a member toexercise controls on capital outflows in order to be

¥1∂ International Financial Institutions Advisory Commission (2000). ¥2∂ IMF Public Information Notice No 01/125.

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eligible for the Fund’s general resources. A Fundendorsement of a standstill would mitigate some-what the detrimental long-term effects on a coun-try’s international standing. However, this mightalso prove insufficient to prevent litigation.

Preventing litigation would probably require anamendment of the IMF articles of agreement. Thisapproach is being debated following a speech by theIMF Deputy Managing Director at the end ofNovember 2001 (1) when she presented a proposalfor an international debt workout mechanism. Thismechanism would take the form of a frameworkoffering a debtor country legal protection from cred-itors that stand in the way of a necessary restructur-ing, provided that the debtor negotiates with itscreditors in good faith and to put in place policiesthat would prevent a similar problem from arising inthe future.

This approach would have the advantage of avoid-ing disorderly debt restructuring. It could also con-tribute to a more stable international financialsystem if it could help to correct market perceptionsthat the official sector will bail out private investorsin case of crisis. The approach could lead, in a firstinstance, to a reduction of capital flows to emergingmarkets but simultaneously also to a better riskassessment by creditors.

However, an international debt workout mechanismrequires a very broad consensus (85 % voting powermajority for an amendment of the IMF articles)since these rules would have to be applied by thewhole membership. If the Fund, and not anotherinternational institution, is empowered to sanctiontemporary capital controls, it could also be seen asplaying the rather irreconcilable roles of referee andfinancial provider. This could create a climate inwhich a crisis could be triggered when the Fundstarts to be involved in a problem country. More-over, reflection will be needed on how to determineif and when the mechanism is formally set inmotion; how to ensure the debtor behaves appropri-ately while he is enjoying protection from his credi-tors; the level of financing that should be providedby the IMF; and the type of debt to which the stayand the binding-in of minority creditors wouldapply.

• A different approach is the proposal of fundamen-tally changing the IMF lending rules to transformthe IMF into an international lender of last resort(LOLR) (see the Calomiris (2) initial proposal whichled to the Meltzer proposal (3)). The IMF (or the to-be-created international central bank) should onlylend short term, at a penalty rate and with collateral toits member countries meeting a set of preconditionsrelated essentially to a well-capitalised and openbanking system (Calomiris) or to sound economicfundamentals (Meltzer). The LOLR approachattempts to address the moral hazard problem associ-ated with IMF assistance, by restricting IMF lendingto sound (illiquid but solvent) debtors that face conta-gion. Both authors assume that the incentive to pre-qualify — and thus for pursuing sound policies orhaving a sound financial system — would be strongsince this would be the only financing window avail-able to countries. Being perceived by financial mar-kets as having sound policies and a sound financialsystem would be a permanent requisite for emergingmarket economies since losing the prequalificationstatus would almost automatically imply huge capitaloutflows. Private-capital markets would indeed beexpected to request a higher risk premium for coun-tries that do not prequalify and thus reduce the incen-tive for over-investment in emerging markets.

The question remains open as to what should bedone with countries that do not meet the conditionsany more and with countries that do not yet meet thepreconditions. The proposal would also deprivemost of the IMF membership of financial support intheir adjustment efforts. Most importantly, theLOLR proposal assumes that the international offi-cial financial community would abstain fromreacting if a non prequalified country would be hitby a crisis. The country would have to face itsadjustment process and the interaction with privatecreditors without Fund support. The problems of theLOLR function are illustrated in someway by thefate of the contingent credit line (CCL), a facilitywhich has some features of a LOLR. The CCLshows how difficult it is to have prequalification asa substitute for ex post conditionality and how hardit will be for emerging market economies tocontinue being perceived as having sound policies.

¥1∂ Krueger (2001).¥2∂ Calomiris (1998). ¥3∂ International Financial Institutions Advisory Commission (2000).

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C.1.3. Excursion: currency transactions taxes

International currency transactions taxes (CTT) have beenproposed as a way to reduce exchange-rate volatility andundesired fluctuations in short-term capital movements.This section will review some of the major CTT proposalsfrom the perspective of their relative effectiveness and ef-ficiency in achieving these objectives.

Within the development community, including develop-ment NGOs, proponents of currency transaction taxeshave emphasised their potential capacity to generate pub-lic revenue. This aspect will be discussed in the context ofpromotion and financing of development in Chapter III.

The concept of currency transaction taxes

The basic idea of discouraging speculative capital transac-tions through taxation has a long history in economic the-ory. Against the background of the differences ofinvestment practices in the UK and the United States pre-vailing at that time, Keynes already in the 1930s presentedthe idea of a transactions tax to counter speculation (1).Nobel-prize winner James Tobin re-launched the idea in1972 and refined it in 1978, when he proposed ‘to throwsome sand in the wheels of our excessively efficient inter-national money market’ (2).

In light of the breakdown of the Bretton Woods systemand the liberalisation of capital movements, Tobin’s pri-mary objective was to give individual countries greaterautonomy over monetary policy. By limiting the scope ofcapital movements, a currency transaction tax would beexpected to expand the room for independent monetarypolicy. The currency transactions tax would discourageshort-term capital movements by making the rapid takingand unwinding of financial positions more costly. Tobinargued that most of the daily transactions were speculationand arbitrage, and contributed little to the efficient alloca-tion of long-term investment worldwide (3).

According to Tobin’s original proposal, the general levyof a flat and low tax rate (1 %) on all spot transactionswould imply a much stronger disincentive for the takingof short-term positions than for transactions related tolonger term investment and financing horizons. There wasthus no need to distinguish between speculative and non-speculative transactions and the administration of the taxcould be simplified. Proceeds of the tax would remainwith national authorities.

While the idea of a currency transaction tax did not re-ceive much attention in the 1980s, it came to the forefrontof the international debate in the mid-1990s. It was arguedthat short-term capital movements were at the root of fi-nancial and economic crises, hampering development andnourishing poverty in many developing countries.

In 1996, Spahn proposed a variant of the Tobin tax. In hisview, Tobin’s original scheme would create liquidityproblems for the day-to-day operations of financial mar-kets while not being effective in case of strong speculativeforces. The Spahn version is based on a two-tier approach:while a tax would apply to all foreign exchange transac-tions and to all financial transactions taking place in thesecondary market of financial derivatives at a normal rateof 0.02 %, a special exchange surcharge would be leviedin periods of exceptional exchange-rate turbulence. Thisimplies the ex ante adoption of some kind of target zonefor the exchange rate around a (moving) central rate. Thesurcharge would apply only when the exchange rate wasmoving beyond the limits of the agreed fluctuation band.The tax base for the surcharge would correspond to thefraction of the value of the transactions carried out aboveor below the defined exchange-rate band.

Schmidt (1999) argued that the implementation of a Tob-in-type tax was technically feasible, provided that the taxwould be levied at the level of the centralised paymentssystems. This system is also used for interbank foreign ex-change transactions and has details of all gross transac-tions in its electronic transfer systems. Schmidt alsosuggests that implementation of the tax by offshore finan-cial centres can be enforced because of the strong links be-tween developed countries’ central banks and offshorenetting systems and securities exchanges. In order to fos-ter compliance with the tax, central banks could refuse ac-cess to their payment and settlement systems if ajurisdiction would not comply with the rules. Centralbanks would act as tax collectors, making a new interna-tional institution for collecting the tax proceeds unneces-sary.

¥1∂ ‘The introduction of a substantial government transfer tax on alltransactions might prove the most serviceable reform available,with a view to mitigating the predominance of speculation overenterprise in the United States. […] Casinos should, in the publicinterest, be inaccessible and expensive, perhaps the same is trueof stock exchanges […]’. However, Keynes also pointed to thedilemma that ‘if individual purchases of investments were ren-dered illiquid, this might seriously impede new investment’. SeeKeynes (1936) as quoted in the paperback edition of Keynes(1964), pp.159–160.

¥2∂ Tobin (1978) and (1984). See also Summers and Summers(1989).

¥3∂ United Nations Development Programme (1994).

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Impact on financial markets

Impact on trade volumes, liquidity and volatility

Assuming that reducing exchange-rate volatility is indeeda desirable goal (1), concerns have been expressed that byreducing the volume of market transactions, liquidity willtighten and as a consequence volatility actually may in-crease instead of being reduced as intended (2). A univer-sal currency transactions tax is expected to increase thebid-ask spreads, deterring primarily arbitrage transac-tions. Arbitrage transactions form a large share of foreignexchange transactions. They take advantage of very smalldifferences in the prices or yields of assets of similartypes. These transactions are usually associated with verylow costs (i.e. very low bid-ask spreads). They take placein the context of financial institutions’ risks managementdaily operations. Such daily foreign exchange transactionshave a similar equivalent in daily liquidity-managementoperations in domestic currencies, where banks exchangevast amounts of money on the inter-bank money market.

According to studies carried out by the FrenchTreasury (3) and under the auspices of the Finnish Minis-try of Finance (4), both of which use similar methodolo-gies for their estimates, trading volumes are expected tofall significantly following the introduction of a currencytransaction tax. For example, with a price elasticity ofone (5) and an initial bid-spread rate of 0.02 % (i.e. thetypical transaction cost before tax on the inter-bank andbank/dealers foreign exchange market), the introductionof a 0.1 % tax would reduce the volume of transactions by83 %. With an elasticity of 0.5, the reduction would stillamount to 69 % (6). The volume of transactions is expect-ed to decline more the higher the tax rate, the higher theelasticity and the smaller the initial transactions cost (7).

The reduction in arbitrage trading would affect the liquid-ity of all markets. Markets in developed countries andtrading among developed countries’ currencies would be

mostly affected, because the lion’s share of currencytransactions are carried out among developed countries’currencies. The following eight currencies pairs (USD/EUR, USD/JPY, USD/GBP, USD/CHF, USD/CAD,EUR/GBP, EUR/CHF and EUR/JPY) accounted for 76 %of the daily foreign exchange turnover in April 2001, withthe two first pairs alone representing 50 % (8).

Transactions among developed and developing countries’currencies or transactions among currencies of developingcountries account for a much lower share of the total for-eign exchange turnover. Trading in local currencies inemerging markets represented about 4.5 % of all transac-tions in 2001, compared with 3.1 % three years earlier.The Hong Kong dollar, the Singapore dollar, the SouthAfrican rand and the Mexican peso were the most widelytraded emerging market currencies, accounting togetherfor 5.3 % of the average daily turnover in April 2001.

In general, lower liquidity bears the risk of higher pricevolatility, which is the opposite of the desired effect. De-spite their relatively low share in international foreignexchange markets, higher transactions costs related tothe introduction of CTT could have disproportionatelystrong effects on the markets of developing countries,where liquidity and trade volumes are already compara-tively small. Empirically, however, no simple link be-tween the volume of trading and volatility can beestablished. For instance, while the trading volumes onthe US dollar/yen market fell between 1998 and 2001,the volatility of the bilateral exchange rate in this perioddid not substantially fall from that observed in the pre-ceding period (9).

Impact on market structure and costs

Analysis suggests that a CTT is likely to contribute to theacceleration of the changes in the structural characteris-tics of the foreign exchange markets (10). Characterisedby the decentralised nature of transactions and the pre-dominance of dealer-to-dealer transactions until now,the introduction of a CTT is expected to further encour-age the concentration of the market, which is already tak-

¥1∂ Some argue that a certain amount of volatility is inherent in thenormal functioning of the national and global financial systems,as it reflects differences in business cycles, discrete shocks, theevolution of risk premiums, and changes in expectations (seeFinancial Stability Forum, 2000).

¥2∂ See Group of Seven (2001).¥3∂ French Government (2000).¥4∂ Ministry of Finance, Finland (2000).¥5∂ An elasticity of one means that the volume of trading falls by 1 %

when the transaction cost rises by 1 %.¥6∂ See Ministry of Finance, Finland (2000), Table A4, p. 56.¥7∂ Indeed, the smaller the initial transaction costs, the more the total

cost increases after the introduction of the tax.

¥8∂ See BIS (2001b).¥9∂ Between April 1995 and April 1998, the exchange rate of the yen

fluctuated between JPY 81 for USD 1 and a peak of aboutJPY 135 to USD 1. Between April 1998 and April 2001, the fluc-tuations were within the 101–147 range. See BIS (2001b).

¥10∂ See Conseil supérieur des Finances du Royaume de Belgique(2001), p. 64.

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ing place under the joint forces of Internet tradingplatforms and concentration in the banking industry.

CTTs may also drive up costs of financing across theboard. Eichengreen (1996) argues that the higher cost ofcurrency transactions due to CTTs would be felt by alleconomic agents, including those developing countries’exporters and importers that rely on foreign trade andcannot use their own currencies in their operations. Thismay have an impact on their price competitiveness,which could counterbalance potential cost savings fromreduced exchange-rate volatility. In addition, dependingon the degree of competition in the market and the ratioof price-supply and price-demand elasticities, the highercost of foreign transactions may be passed on to finalcustomers.

Impact on speculative flows

Proponents of currency transaction taxes often arguethat, apart from reducing volatility, the tax could help indiscouraging large speculative trading operations (1).There is obviously a trade-off between, on the one hand,effectively discouraging potentially undesired capitalflows and, on the other hand, not unduly discouraging in-ternational transactions and ensuring sufficient liquidityto the markets (2). It is generally acknowledged that at alow rate, the tax would be an insignificant cost in timesof currency turmoil. But even at the relatively high rateof 1 % (2 % on a round trip), a currency transaction taxmight not prevent speculation, which is usually associat-ed with the expectation of strong exchange-rate move-ments, e.g. when market participants consider that acountry’s fixed exchange rate has become unsustainableand is on the verge of being abandoned. A simple calcu-lation shows that, at a rate of 1 %, the tax would not detera one-week speculative position if there were a 50 %probability of a 4 % devaluation during the week. Ahigher probability and/or a higher expected exchange-rate change would make the speculative position-takingmore profitable than the tax.

Taking this challenge into account, Jetin (2001) argues,within the framework of Spahn’s two-tiered approach,that the tax rate would need to be allowed to increase to

‘ […] much higher levels than was expected until now’.Alternatively, he suggests to design a variable CTT withthe tax rate being a function of the depreciation or appre-ciation rate of the foreign exchange rate. Depending onthe details of the function, this could imply prohibitivelyhigh transaction taxes in times of crisis, essentially mim-icking the effect of a standstill.

C.2. Reducing the abuses of the financial system

Money laundering and harmful tax practices

There is an increasing awareness of the need to tackle allsources of international financial abuse in order to guar-antee a fair and more efficient economic system. Opaquetax and financial systems and the absence of effectivecooperation with foreign authorities in some jurisdic-tions — in particular a number of financial and tax ha-vens — make it very difficult to curb tax evasion ormoney laundering. Most States have, however, realisedthat it is in their best interest to agree on a number ofcommon standards in the financial and tax fields and rec-ognise that a certain coordination of fiscal or financialpolicies can increase their autonomy regarding domesticpolicies.

A number of forums aimed at improving standards of fi-nancial regulation and at eliminating harmful practicesare now in place. These include the Financial StabilityForum (FSF) of the G7, the Financial Action Task Force(FATF) and the Forum on Harmful Tax Practices of theOECD.

The Financial Action Task Force (FATF) was estab-lished in 1989 and comprises 31 members, including theEuropean Commission and the 15 EU Member States. Itadopted in June 2000 a report aimed at identifying unco-operative States and territories in the fight against moneylaundering. Until now, 19 countries and territories havebeen considered uncooperative. A dialogue has startedwith these jurisdictions to encourage them to put an endto their uncooperative practices and modify their legisla-tion. For the countries and territories that maintain theirharmful practices, defensive measures will be imple-mented. So far, defensive measures have only beenproposed against Nauru which take effect from30 November 2001.

The G7 Financial Stability Forum (FSF) was created in1999 with the objective of assessing vulnerabilities in

¥1∂ Again, some argue that this should not be by definition beneficialto the countries themselves; see for instance Soros (2001), whopoints out that the adoption of CTTs could reduce the discipliningfunction of integrated capital markets.

¥2∂ See for example the report of the French Government (2000) orthe report from the European Banking Federation (2001).

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the international financial system, identifying and over-seeing action needed to address those vulnerabilities,and improving coordination and information exchangeamong the various authorities responsible for financialstability (1). The FSF has worked on several topics, in-cluding the activities of highly leveraged institutions andoffshore financial centres. In a report published in April2000, the FSF identified three groups of jurisdictionswith regard to adhesion to minimum standards of trans-parency and cooperation. Group III, which is character-ised by a lack of transparency and cooperation, includes25 jurisdictions towards which the FSF proposes coordi-nation of international initiatives.

The OECD Forum on Harmful Tax Practices was set upin 1998 following the publication of the OECD report‘Harmful tax competition. An emerging global issue’. Alist of 35 jurisdictions meeting the tax havens identifica-tion criteria set out in that report was published in June2000. A dialogue aiming at encouraging these jurisdic-tions to adopt fair tax practices is currently being under-taken. Since the start of its work, the Forum has obtained11 political commitments to cooperation (2). In 2002, theadoption of defensive measures towards uncooperativejurisdictions will be proposed on the basis of a list of un-cooperative jurisdictions established as at 28 February2002.

Within the European Community, important progresshas been achieved in the fight against money launderingand harmful tax practices. The Council and the EuropeanParliament adopted a revised and improved directive onmoney laundering on 4 December 2001, in order to makeit more comprehensive and to ease the fight against in-ternational terrorism and other criminal activities. In thetax field, substantial progress towards the elimination ofharmful tax practices has been achieved in the frame-work of the tax package endorsed by the Council on the1 December 1997. The European Commission has pre-sented an amended proposal for a directive on the taxa-tion of savings income in July 2001 and has now enteredinto negotiations with key third countries in order to en-sure that equivalent measures are taken there. Progress isalso being made in the field of corporate income taxa-

tion. The code of conduct for business taxation shouldlead to the progressive roll back of 66 harmful tax meas-ures in this field.

Fighting financing for terrorism

Specific action against terrorist financing has increasing-ly come into focus. Several measures have been takenfollowing UN Security Council Resolution 1 333 tofreeze assets of targeted persons and organisations asso-ciated with the Taliban. In addition, parallel work at theFATF and among supervisors has started as well as thestrengthening of provisions used to combat money laun-dering. While no claim can be made that such measureswill eliminate terrorist financing, they have led to in-creased cooperation between relevant authorities and ad-ditional pressure on illicit financing circuits.

Although money laundering and the financing of terror-ist activities have some features in common, they aresubstantially different in nature. While the first one in-volves laundering illegally obtained money (hence dis-guising its origin), the other represents almost theinverse i.e. the processing of funds, often from legitimateorigins, to be used for future crimes. A further complica-tion is that completely legal donors can fund terroristgroups through perfectly legitimate-looking charity do-nations that could ultimately end up in the hands of ter-rorists. Thus, legitimate money can finance activitywhich might be illegal but the intention in respect of thedonor cannot be established.

With respect to fighting financing for terrorism, theCouncil adopted in March 2001, on the basis of a Coun-cil common position (3), Regulation 467/2001 (4)strengthening measures in respect of the Taliban of Af-ghanistan on the basis of UN Security Council Resolu-tion 1 333. The applicable lists of entities andindividuals, the accounts of which were frozen in theEU, included the Al-Qaida organisation and Usama BinLaden as well as nine other associates. The regulationwas amended several times to reflect a consolidated listof persons and entities, established by the UN Taliban

¥1∂ The forum has a total of 40 members: 25 from national authorities,14 from international financial institutions, regulatory and supervi-sory groupings and committees of central bank experts and a chair-man. The FSF meets usually twice a year (spring and autumn) butcan meet as often as needed to carry out its functions.

¥2∂ OECD (2001d).

¥3∂ Common position 2001/154/CFSP of 26 February concerningadditional restrictive measures against the Taliban (OJ L 57,27.2.2001, p. 1).

¥4∂ Council Regulation (EC) No 467/2001 of 6 March 2001 prohibitingthe export of certain goods and services to Afghanistan, strengthen-ing the flight ban and extending the freeze of funds and other finan-cial resources in respect of the Taliban of Afghanistan, and repealingRegulation (EC) No 337/2000 (OJ L 67, 9.3.2001, p. 1).

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Sanctions Committee, to whom the freeze of fundswould apply.

Misuse of corporate entities

The prevention of the misuse of corporate vehicles (1)for illicit purposes is seen as an important element of asuccessful strategy to curb the abuses of the internationalfinancial system (2). While the diversity of corporate en-tities, comprising corporations, trusts, foundations andpartnerships with limited liability features, is a well es-tablished feature of the global economic system, somecorporate vehicles are set up mainly to conceal the iden-tity of the owners and/or beneficiaries of such entities.They can thus be misused for illicit purposes, includingmoney laundering, the circumvention of disclosure re-quirements, bribery and corruption, hiding and shieldingassets from creditors and supporting unlawful taxpractices (3).

Proposals to combat the unlawful use of corporate struc-tures stress the need to enhance their transparency. Inparticular, several mechanisms are proposed to obtainthe necessary information on beneficial ownership andcorporate control (4). The first approach would be to in-troduce disclosure requirements about the beneficialowners and the control structure upon the establishmentof a new corporate entity as well as each time the corpo-rate structure is modified. A second approach would relyon intermediaries as the main source to supply the de-sired information. Such intermediaries would includeformation agents, trust companies, and lawyers, etc. in-volved in the formation and management of corporatevehicles. The third approach would operate through in-vestigative measures such as court subpoenas and housesearches. Depending on the conditions and traditionsprevailing in different jurisdictions, the three mecha-nisms could be combined to reinforce their effective-ness.

In addition to increasing the transparency of corporatestructures, the OECD recommends ensuring that appro-priate and sufficiently integrated oversight capacities are

in place. Moreover, non-public information on benefi-cial owners and corporate control should be shared withother relevant supervisors and law-enforcement authori-ties, both domestically and internationally, for the pur-pose of investigating illicit activities, fulfilling theirsupervisory functions and facilitating compliance withthe requirements embodied in anti-money launderinglaws, such as customer identification.

Towards better coordination

Some have claimed that the international fight againstabuses would benefit from a more coordinated approach.One option would be to set up new international institu-tions to cope with these matters. In that view, globalproblems, such as in the tax and financial fields, are bet-ter dealt with at global level and using ‘global’ instru-ments. Also, in a truly international forum, developingcountries — which have arguably suffered as much asany country from the effects of financial abuses —would have a greater voice, as of course would many ofthe financial and tax havens and offshore centres. In thisway, the perception of a ‘rich man’s club’ ganging up onsmaller, and in some cases poorer, countries would beovercome. However, it should be underlined that mosttax and financial havens are relatively well-off countries,while the adverse consequences of unfair practices areborne by both developed and developing countries.

An alternative would be to work with existing institutionsand ensure better coordination of regional and internation-al organisations. Existing institutions such as the FATF orthe OECD have already obtained considerable results; anumber of jurisdictions are now moving towards fairerpractices in the financial and tax fields as a result of theirwork. If a new organisation were to assume the lead in ar-eas such as harmful tax competition, there is a strong riskof losing much of the momentum already achieved andpositive results, such as commitments by a number of ju-risdictions to remove harmful features of their tax re-gimes, could be put in jeopardy. Furthermore, it is alsopossible that harmful criteria and the remedies could bemade much weaker than at present due to the mere partic-ipation of tax and financial havens in the decision-takingof the new institution. Lastly, it is unlikely that creatingnew organisations would overcome the aforementionedlegitimacy problems. Indeed, such organisations wouldrequire both a wide country membership to give their pro-posals legitimacy and either the ability to reach a consen-sus or some other means of enforcing the majority view.Complex decision-taking processes may ultimately lead

¥1∂ The OECD (2001) in its report on the misuse of corporate entitiesfor illicit purposes defines corporate vehicles as ‘legal entitiesthrough which a wide variety of commercial activities are con-ducted and assets are held.’

¥2∂ Financial Stability Forum (2000) and G7 Finance Ministers(2000b).

¥3∂ OECD (2001e).¥4∂ OECD (2001e).

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to unsatisfactory results from the point of view of both de-veloped and developing countries.

C.3. Regional and global cooperation

This section discusses initiatives to enhance the stabilityof the international monetary system by intensified mac-roeconomic coordination within the context of regionalgroupings and among the G3.

Regional macroeconomic and monetary cooperation

Regional macroeconomic and monetary cooperation havebeen advocated as a way forward to spur regional economicintegration and make small and relatively open economiesmore resilient to external disturbances (1). While for largeeconomies, such as the United States, Japan and the euro ar-ea, the repercussions of large swings in exchange rates onthe real economy tend to be moderate, for emerging marketeconomies and developing countries the impact can be sig-nificant. They may thus have a particularly strong interest inan exchange-rate system that ensures a maximum level ofstability.

However, the Asian crisis has underlined that the glo-balisation of financial markets and the high level of in-ternational capital mobility are rendering the policyrequirements for maintaining pegged exchange ratesmore demanding. It is often argued that for open emerg-ing market economies, floating exchange rates are themost viable solution (2). There is, however, universalrecognition that any viable exchange-rate policy needs tobe consistent with and backed up by domestic economicand financial policies.

Dornbusch (2001) stresses the importance of regional fi-nancial market integration. He argues that as capital mar-kets are broadening and deepening in response toprogressing integration, the exchange rate becomes lessimportant as an instrument of adjustment in the case of anegative shock. The capital market would be able to takeover an important part of the buffer functions typicallyassigned to exchange rates.

This line of reasoning is consistent with the European ex-perience. European economic and monetary union has cre-ated a pole of monetary and financial stability for Europefuelling further market integration and growth dynamics.

Enhanced macroeconomic and exchange-rate cooperationamong the Member States has complemented and rein-forced the internal market project to generate growth andstability for the European Union. The experience of finan-cial turbulence and strong intra-European exchange rateswings in the beginning of the 1990s have enhanced thecommitment to move ahead with monetary union. Themodest impact on EU financial markets of the 11 Septem-ber attacks indicate that Member States with their move toa single currency have successfully reduced the vulnerabil-ity of their economies to external financial turbulence.

While the EU situation cannot be translated to other re-gions without qualification, the experience of the Euro-pean Community on its way to economic and monetaryunion provides a good benchmark to analyse the sequen-cing and the necessary conditions for successful regionalmonetary cooperation. Essential ingredients include poli-cy coordination on the basis of a shared philosophy on fis-cal discipline; shared views on price stability; and someform of institutionalised multilateral monitoring. Giventhe free movement of capital and the desire to stabilise theexchange rate between Member States, the convergenceof monetary policy rules is inevitable.

Bearing in mind the lessons from the Asian crisis, theAsian economies in the context of the Manila Frame-work and the Chiang Mai Initiative have made someprogress in enhancing financial and monetary coopera-tion in the region (3). Some argue that it could bebeneficial for East Asian emerging market economies,particularly ASEAN countries, to move towards a re-gional system of managed exchange rates. In order tostabilise the system in the beginning, appropriate meas-ures to curb excessive capital flows could be envisaged.Over time, however, as the system would become morerobust, these restrictions could be removed to ensure thedevelopment of a functioning capital market in theregion (4).

In the Americas, the approach to monetary cooperationappears to be less systematic. Monetary coordination isnot included in the framework establishing the North

¥1∂ For example Frankel and Rose (1996) and Rose (2000).¥2∂ Mussa et al. (2001).

¥3∂ The Manila Framework sets the ground for regional financial andmonetary surveillance and foresees cooperative financial arrange-ments for participating countries in times of financial crisis.Members include Asian and non-Asian countries, such as theUnited States. The Chiang Mai Initiative is designed to expandexisting swap arrangements among ASEAN countries, China,Japan and the Republic of Korea.

¥4∂ See Kuroda (2001).

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American Free Trade Agreement. The United States,Canada and Mexico operate exchange-rate regimes offree floating with different degrees of de facto manage-ment. Within Mercosur, a wide range of exchange-rateregimes exist. While Brazil has adopted a system of freefloat, Ecuador and El Salvador, and until recently Argen-tina, chose a currency board or have decided to unilater-ally adopt the US dollar as their home currency. Thisraises questions whether the existence of different ex-change-rate regimes is compatible with the objective ofregional economic integration.

For regions with a dominant regional economy such asthe euro area for Europe and the United States for NorthAmerica, it has been claimed that improved monetarycooperation and progressing currency consolidation onthe periphery can deliver important systemic gains.Some authors suggest that NAFTA provides a good ar-gument for closer cooperation between the UnitedStates, Canada and Mexico. Dornbusch (2001) arguesthat particularly the latter could benefit from permanent-ly pegging its currency to the US dollar via the introduc-tion of a currency board. With the prospect of fewercrises on the periphery, improved regional stability andgrowth potential, the centre, therefore should take an ac-tive interest if not leadership in promoting regional mon-etary cooperation (1).

Macroeconomic policy cooperation among the G3

The economic developments of the three major currencyareas have substantial repercussions on the world econ-omy as a whole. Against the background of growing eco-nomic and financial interdependence, and the increasedpotential for more sudden and deeper spillover ofshocks, a number of proposals have been made to en-hance macroeconomic and particularly exchange-ratepolicy coordination among the G3 (2).

Most proposals advocate the creation of a target zone forbilateral (nominal) exchange rates. As unilateral target-ing tends to be less effective than mutual action, a G3 tar-get zone would typically require a trilateral agreement

on bilateral target rates; a mutual understanding aboutwho is doing what in case of the observed exchange ratemoving away from the agreed target rate as well as aboutthe margins beyond which action is required. Targetzone proposals can thus vary regarding the size of theband and the rules for intervention (with or without inter-marginal intervention, symmetric or asymmetric inter-vention, etc.).

The mechanism proposed by Wolf (1999) is less ambi-tious by comparison. He proposes for the euro area andJapan to unilaterally define a ceiling on their respectivebilateral exchange rates vis à vis the dollar. In that sce-nario, the ECB and the Bank of Japan would conductmonetary policy in such a way as to ensure that the re-spective bilateral exchange rates would not exceed a cer-tain threshold. This proposal was motivated by the viewthat the appreciation of the bilateral euro/dollar and theyen/dollar rates above desirable levels was more likelythan a depreciation to undesired levels and that the risksassociated with a possible overvaluation of the euro andthe yen are bigger than the risks associated with a weak-ening of both currencies. In contrast with the concept ofa target band, Wolf’s proposal is an asymmetric ap-proach, which could be effective for the euro area and Ja-pan to avoid that their exchange rates rise to levelsconsidered unhealthy for their respective economies.However, it provides no rule in case of swings in the op-posite direction.

The design for a new global exchange-rate system advo-cated by Mundell (2001) is the most ambitious. Giventhe high degree of inflation convergence among the ma-jor currency areas, he argues that some sort of monetaryunion of the G3, that is a single world currency, isfeasible and desirable. This would require, a common in-flation target, a joint rule for monetary policy and agree-ment on the distribution of seigniorage. Mundell’sproposal has triggered an ongoing academic debateabout the desirability of a single world currency. In ad-dition to the economic arguments raised against fixedexchange rates, Rogoff (2001) identifies a number offundamental reasons against a global currency unifica-tion, including: (i) no adequate checks and balances onthe global central bank due to the absence of a globalgovernment; (ii) international decision-making couldmake it difficult to agree on appointing central bankerswho place a strong weight on price stability; (iii) globalcurrency competition provides a check on inflation.

¥1∂ See Portes (2001) and Dornbusch (2001). Concerning the eurothe ECB (1999), p. 45, does not share these conclusions andreports that the Eurosystem has adopted ‘[…] a neutral stance,neither hindering nor fostering the international use of its cur-rency.’

¥2∂ For example Volcker (1995), Williamson (1986), McKinnon, R.(1997), Wolf (1999) and Mundell (2001). For a survey of some ofthe proposals see Clarida (1999).

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In general, proponents of an engineered stabilisation ofexchange rates argue that the targeting of exchange ratesamong the G3 currencies would increase the overall sta-bility of the international monetary and finance system,implying fewer crises and higher growth for both themajor currency areas as well as the emerging marketeconomies and developing countries. The cost of inter-national transactions would diminish, boosting econom-ic integration. For economies located at the periphery ofthe major currency areas, it would become less risky topeg their currency to one or to a basket of key currencies.In some cases, countries would be expected to give uptheir home currency altogether to be substituted by oneof the major currencies.

However, empirical evidence seems to suggest that for theG3 the repercussions of exchange rate swings on trade andinvestment are much slower and less pronounced than onewould expect by looking at the extent of changes impliedin variations of bilateral nominal exchange rates (1). In ad-dition, under fixed exchange-rate systems, monetary poli-cy authorities lose to a significant degree the ability toreact independently to external shocks and domestic poli-cy priorities. This can imply significant welfare losses incase of asymmetric shocks (2). Obstfeld and Rogoff(2000) argue that ‘continued improvement of monetarypolicy institutions at domestic level, coupled with the fur-ther broadening of world capital markets, may renderefforts towards closer exchange-rate coordination super-fluous or even counterproductive.’

Moreover, some claim that under a regime of fixed ex-change rates, monetary policy itself can become a genu-ine source of policy shocks. (3) With free capitalmovements, G3 authorities have to use domestic mone-tary policy as a tool to stabilise exchange rates. As a re-sult, the variability of interest rates and monetaryinduced changes in domestic income and demand mayrise. Against this background, the benefits for emergingmarket economies from stabilising exchange rates be-

tween the G3 countries are therefore not clear cut. Whileunder a system of target zones, the relative prices foremerging market economies may become more stable asG3 exchange rates become more predictable, the in-creased variability of interest rates and G3 income mayincrease uncertainties for emerging market economiesrelated to external financing and external demand. Thewelfare effect for an emerging market economy of a G3target zone depends on how this zone is designed and onthe particularities of the small country’s output, tradingpartners and debt structure. To the extent that an emerg-ing market economy is vulnerable to high and volatileworld interest rates, the consequences of the trade-offimplied by a G3 target may be considerable.

C.4. Towards improved governance

The IMF has until now remained the institution wherethe formal decision-power related to the internationalmonetary and financial system is vested. The substantialincrease in its membership has transformed it into a glo-bal institution and the broadening scope of IMF taskshave been accommodated without substantial changes inthe institutional setting or the decision process. The rel-ative quota share of the founding members, mainly in-dustrial countries, has declined but advanced countriescontinue to retain a comfortable majority in voting pow-er, with the United States still enjoying a de facto vetowith respect to major decisions (4). New members wereadded to existing constituencies chaired by one of thefounding members or, if the new member waseconomically important like Russia, China, and Switzer-land, were allowed to form new constituencies through agradual increase in the number of executive directorsand members of the International Monetary and Finan-cial Committee to 24.

The calls for more legitimacy, more accountability, andbetter governance for the Fund take place in the contextof growing concerns of emerging market economiesabout the continued predominance of advanced coun-tries in the IMF decision process and in informal forumswith limited membership, such as the G7. They go inparallel with requests from NGOs and national parlia-ments for increased accountability since the IMF is alsoperceived by some as an excessively technocratic andnot-transparent institution.

¥1∂ See Rogoff (2001). Contrary to the link between volatility andtrade, Sekkat (1997) reports that there is a consensus in the eco-nomic literature on the negative impact of exchange rate mis-alignment on trade.

¥2∂ The relevance and magnitude of this effect depends on variousfactors, such as the degree of economic integration and correla-tion of macroeconomic conditions. Advocates of target zones,such as Bergsten and Henning (1996) argue also that (a) adjust-ment to shocks should be dealt with by the real economy, (b) tar-get bands leave some room for independent monetary policy and(c) that if necessary revisions of the target rate are not excluded.

¥3∂ Reinhart and Reinhart (2001). ¥4∂ Major decisions are taken by a majority of 85 % of the total vot-

ing power.

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Various proposals have been made to address these con-cerns. Some of them have been partly or fully implement-ed, others lack sufficient political support. The complexityof the issues and the conflicting objectives explain why sofar changes in this area have been relatively limited. Morerecent changes and proposals include the following.

• The creation, outside the IMF, of groups such asthe FSF (see Section C.2) and the G20. The G20was created in September 1999 as an informal mech-anism for dialogue among 20 major industrialisedand emerging market economies. While both forumsserve a useful purpose, increasing the number ofinformal groups risks adding to the confusion andultimately complicating the decision process sincethese forums lack legitimacy and non-participantsdo not feel involved.

• Increasing the transparency of the decision process.The IMF has made efforts to publish its board proceed-ings and to explain its decisions to the public. Transpar-ency has, however, its limits: difficult decisions mayrequire a certain degree of confidential dialogue beforebeing taken. Moreover, NGOs and national parlia-ments not only want transparency but also wish to be ina position to influence decisions taken by the IMF. It isnot entirely clear whether indeed the legitimacy ofdecisions taken by the Fund would be increased if theFund’s operations were taken on the basis of criteriaother than ‘objective’ criteria or if the Fund would beaccountable to more groups. Furthermore, making theFund accountable to anything else but its membership(as is now the case through the Board of Governors)seems a rather unworkable principle. Whereas havingfor instance national parliaments endorse decisionswould probably help to increase legitimacy, it wouldmost likely bring the operations of the institution to ahalt.

• Transforming the IMFC into a council with deci-sion power (1). This would have the advantage of giv-ing more political weight to the IMF and increasingaccountability by leaving important decisions to betaken by ministers, rather than by the executive board.The creation of the permanent IMFC, replacing theinterim committee is a step in this direction. Creating acouncil would transform the IMF into a much more

political institution. It would also risk complicating therelations between the board and the council.

• Re-balancing the decision power within theFund. Various avenues have been suggested,including changing the quota formulas or increasingthe number of basic votes. Progress on that front isconditional upon the recognition that calls for amore balanced involvement of emerging marketeconomies are legitimate and should be supported.

• Clarifying relations between the IMF and theWorld Bank. Though there is a widely acknowl-edged need for improved cooperation and clearerdivision of labour between the Fund and the WorldBank and other development agencies, proposals tothat end differ substantially. Some would like to sep-arate more clearly IMF and World Bank functions(Meltzer Commission). This would translate intoshifting concessional or development financing bythe Fund to the World Bank and by having the IMFfocus narrowly on its monetary and crisis role. How-ever, others stress that the IMF is a quasi-global insti-tution that should assist all its members. It also has aunique expertise in designing sound and consistentmacroeconomic policies and in putting in place thekey elements for a global growth strategy. Withoutfinancial support to these countries, the IMF wouldhave no leverage. Again others would like to see amerger of some IMF and World Bank departments todeal with development issues. Practical arrangementsrisk, however, being quite complex.

• Creating new overarching bodies, such as a globalgovernance group or a UN Economic Security Coun-cil. In a recent report on global governance, Camdessusand others (2) recommend to complement the currentG7/8 mechanism by a high-level global governancegroup (3G). This group would include the 24 Heads ofState or Government that have executive directors inthe boards of the IMF and the World Bank. In theirview, this would balance the double objective of effi-ciency in decision-making and maximum representa-tivity, as all countries would be represented eitherdirectly — the five countries holding the largest shareof quotas — or within the established framework ofregional constituencies. The 3G would monitor trendsand policy developments in the field of global eco-

¥1∂ As suggested in 1998 by Minister Strauss-Kahn. ¥2∂ Comece ad hoc Group on Global Governance (2001).

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nomic, social and environmental issues, and assurecoherence, coordination and arbitration among themajor international organisations. Like in similar pro-posals, annual meetings at Head of State level woulddecide on key issues of strategic concern, such as thecreation of new institutions. 3G summits would bejointly prepared by a network of Sherpas and the staffof the UN, the Bretton Woods institutions, the WTO,the ILO and the World Environment Organisation to beestablished. The heads of these institutions would par-ticipate in the meetings.

A variety of sources have advocated the creation of a UNEconomic Security Council (ESC) (1). As with the 3G,the purpose of such a Council would be to provide lead-ership on global economic, social and environmental is-sues; in contrast with the previous proposal it would beestablished under the auspices of the UN by comple-menting the Security Council. The Council would con-tinuously assess the state of the world economy and theinteraction between the major policy areas; provide a

long-term strategic policy framework in order to pro-mote stable, balanced and sustainable development; andsecure consistency between the policy goals of the majorinternational organisations, particularly the BrettonWoods institutions and the WTO, while recognisingtheir distinct roles.

Proponents of an ESC argue that it could enhance theauthority of the IMF and the World Bank and maketheir work more effective, by providing guidance,which is based on conclusions of a more representativebody than the Group of Seven. The Council would haveno legally binding power, but would act as a steeringgroup for global governance and provide leadershipthrough the quality of argument and the authority de-rived from its membership. Membership would be lim-ited to some 23 members. It would include the largesteconomies (in terms of GDP measured in purchasingpower parity) and be open to representatives of signifi-cant regional organisations such as the European Unionand ASEAN. Meetings would be held once a year at thelevel of Heads of State or Government and more fre-quently at the level of ministers of finance and/or eco-nomics and trade. A constituency system, rotation andconsultation mechanisms are envisaged to ensure thatthe broader membership of the UN is represented in thedecision-making of the ESC. Moreover, the relation-ship between the General Assembly and the ESC wouldneed to be defined.

¥1∂ See, for instance, the Commission on Global Governance (2001)(www.cgg.ch). Initiated by the former chairs of various UN-related commissions on development, the Commission on GlobalGovernance was established in 1992 comprising 24 members,including former Heads of State or Government, internationalorganisations, and ministers. They serve in their personal capac-ity. Ingvar Carlsson, former Prime Minister of Sweden, andShriddath Ramphal, former Secretary-General of the Common-wealth, are chairing the Commission.

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Chapter III

Promoting and financing development

Introduction

The benefits of globalisation have not been shared by all,and more remains to be done for the poorest countries toavoid further exclusion and marginalisation. As outlinedin Chapter I, even though in the past decade the share ofthe population living on less than USD 1 a day has actu-ally decreased to 24 %, the number of people below thepoverty line has remained at around 1.2 billion, with anadditional 1.6 billion living on less than USD 2.

The failure of poor countries to ‘catch up’ has been at-tributed to poverty trap conditions of subsistence in-come, low savings and investment, low levels ofeducation and high fertility. A related argument comesfrom those who stress that poor people remain poor orget poorer not because of globalisation, but because theyare excluded from it. The logical response would bemore openness to the world economy; however, aseconomic liberalisation may not necessarily promoteequality convergence, accompanying policies are as im-portant.

In terms of development policy, it has become clear thatmeasures in developing countries that strengthen eco-nomic growth alone are not enough. There is now agrowing consensus that increased emphasis has to be puton poverty reduction, which should be the primary ob-jective of development cooperation. This has been re-flected in the Millennium Declaration of the UN GeneralAssembly (1). It has also been recognised that measuresshould not be imposed from outside, but should be basedon a participatory process.

In addition, while for a long time the UN, World Bankand IMF were seen as offering different perspectives ondevelopment, these differences have now narrowed withthe World Bank embracing the basic principles of socialdevelopment and the UN giving more attention to macr-oeconomic discipline and open markets.

The concept of poverty has changed over the years.There is now agreement that poverty goes beyond thelack of income and financial resources, and includesnon-monetary factors such as the lack of access to edu-cation, health, natural resources, employment, land andcredit, political participation, services and infrastruc-tures. These elements are seen as essential to allow peo-ple to take control of their own development, enjoyequality of opportunity, and live in a safer environment.

The upcoming UN Financing for Development Confer-ence scheduled for March 2002 in Monterrey has fo-cused the discussions on how best to achieve the overallobjective of poverty reduction. Most of the issues atstake have been raised in the so-called Zedillo report(United Nations, 2001b) commissioned to a high-levelpanel by the UN Secretary-General Kofi Annan in De-cember 2000. It focuses on the mobilisation of domesticand foreign resources (be it foreign direct investment orODA), promotion of international trade, and sustainabledebt financing.

Many of these elements will be touched upon in thischapter. A first part assesses the various existing instru-ments contributing to development processes and reduc-tion of inequalities, such as ODA, debt reduction, marketaccess and foreign direct investment, and looks at waysto improve their effectiveness for poverty reduction. Thesecond part reviews various alternatives for financing fordevelopment, including fiscal mechanisms at interna-tional level.

¥1∂ The declaration spells out the following eight millennium developmentgoals: eradicate extreme poverty and hunger; achieve universal primaryeducation; promote gender equality and empower women; reduce childmortality; improve maternal health; combat HIV/AIDS, malaria and otherdiseases; ensure environmental sustainability; develop a global partnershipfor development. On the need for specific and quantifiable developmentgoals, see also the 1996 report of the Development Assistance Committee(DAC), the principal body through which the OECD deals with issuesrelated to cooperation with developing countries.

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A. Assessment of existing instruments

A.1. ODA

Official development assistance (ODA) is defined by theOECD as the sum of grants and concessional loans (i.e.with a grant element of at least 25 %) undertaken by theofficial sector and with the primary objective of promo-tion of economic development. The measurement ofODA is, however, not straightforward. World Bank ex-perts criticise it on three accounts (1): underestimation ofaid content due to netting out (2), misrepresentation ofthe correct level of concessionality (the loans are fullycounted, even if the grant element may only be at 25 %)and on the calculation of the grant element itself. Anoth-er criticism derives from the observation that donorcountries have brought over the past two decades a vari-ety of public expenditures under the heading of ODA,such as the cost of development administration, educa-tion costs for students from developing countries, emer-gency and disaster aid and cancellation of debts (3).Calculations of ODA flows between 1990 and 1994

would have been 35 to 42 % lower, had the original def-inition been strictly applied.

A.1.1. Trends in ODA and the 0.7 % target

On the whole, trends in ODA have been disappointing.While total long-term capital flows to developing coun-tries increased from USD 98 billion in 1990 to overUSD 295 billion in 2000, ODA stayed at USD 53 billionover the same period (Table 2) (4).

In terms of percentage of DAC members’ (5) GNP, theshare of ODA decreased from 0.33 % in 1990 to 0.22 %in 2000 (back to the level of 1997) (6), and hence furtheraway from the recommended aid target of 0.7 %. Ac-cording to the 2001 DAC report, only five OECD mem-bers (Denmark, Luxembourg, Netherlands, Norway andSweden) have reached in 2000 the level of 0.7 % GNP tobe spent on ODA (Figure 9), while the EU on averagehas reached 0.33 %.

¥1∂ Chang et al. (1999).¥2∂ By netting out amortisation payments, the net flow of ODA, i.e. disburse-

ments minus amortisation, underestimates the aid content of flows. As anexample, a constant flow of identical highly concessional loans would rep-resent a continuous cost for the donor but would lead to a zero net ODAflow, as amortisation flows would exactly match aid flows.

¥3∂ Mertens (2001).

¥4∂ OECD (2002).¥5∂ The 23 members of the Development Assistance Committee (DAC) of the

OECD are: Australia, Austria, Belgium, Canada, Denmark, Finland,France, Germany, Greece, Ireland, Italy, Japan, Luxembourg, Netherlands,New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, UnitedKingdom, United States, as well as the European Commission.

¥6∂ For comparison, in 1999 the ODA relative to all developing countries’GDP was 0.6 %, compared to 1.4 % in 1990 (UNDP, 2001); this decline isalso evident for the LDCs, who saw their percentage fall from 11.6 to 7 %,over the same period.

Table 2

Net long-term flows to developing countries, 1990–2000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Total (billion USD) 98.5 123 155.8 220.4 223.7 261.2 311.2 342.6 334.9 264.5 295.8

Official flows 56.8 % 49.5 % 36.3 % 24.3 % 21.5 % 21.1 % 10.3 % 12.5 % 16.3 % 17.1 % 13.0 %

Private flows of which: 43.2 % 50.5 % 63.7 % 75.7 % 78.5 % 78.9 % 89.7 % 87.5 % 83.7 % 82.9 % 87.0 %

Debt flows 36.9 % 30.3 % 38.4 % 29.5 % 28.7 % 30.6 % 35.3 % 32.4 % 31.4 % -0.3 % 12.2 %

Equity flows 6.6 % 12.2 % 14.2 % 30.6 % 20.0 % 17.5 % 17.6 % 10.1 % 5.6 % 15.7 % 18.6 %

FDI 56.6 % 57.5 % 47.4 % 39.9 % 51.2 % 51.9 % 47.1 % 57.6 % 63.1 % 84.6 % 69.2 %

Source: World Bank (2001a).

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C h a p t e r I I IP r o m o t i n g a n d f i n a n c i n g d e v e l o p m e n t

The origin of the 0.7 % target dates back to the 1969 Pear-son report (1), where it was calculated that a resourcetransfer of 1 % of GNP would allow the 6 % growth in de-veloping countries judged necessary to lift them from aid-dependency. With private-capital flows estimated in 1969at 0.3 %, official flows would have to bridge the gap of0.7 %. At the time, it seemed to be an ambitious yetachievable goal. In reality, if in 1968 ODA level as a per-centage of GNP was 0.48 %, in the early 1970s it fell dra-matically to between 0.30 and 0.35 % (probably also dueto the oil-crisis), and it remained stable for 20 years. At thebeginning of the 1990s, the end of the cold war broughtnew hopes of a ‘peace dividend’ from reduced military ex-penditures that could be used for development assistance,which were however not fulfilled as pointed out above.This may be linked to the recession of 1992–93 and thedonors’ efforts to bring their own budgets back into bal-ance, but it also reflects the donors’ willingness to ensurean effective use of existing ODA resources before increas-ing the volume further (OECD, 2000).

Over the years, all DAC members, except Switzerlandand the United States, have accepted the 0.7 % target,even if the degree of commitment has varied widelyfrom firmly agreed budget allocations and target dates tomore general statements. At the European Council ofJune 2001 in Gothenburg, the EU committed to reach theUN target as soon as possible and is currently looking tohave a clear road map for setting out the way it intendsto reach these financing goals (2).

As far as non-EU donors are concerned, despite the re-duction of its aid, Japan remains in 2000 the leadingcountry in providing bilateral ODA (USD 13 billion),with the United States the second largest provider (aboutUSD 10 billion). The role of non-DAC members(former-CMEA and Arab countries) peaked in the mid-1970s, when they made available 30 % of total ODA,while nowadays 95 % of ODA is provided by DACmembers. Figures for the CMEA were rather difficult toestimate though, as aid was often in kind at unpublishedprices; moreover, aid from China was not included.More recently, new OECD donors are emerging such asKorea, Turkey, and three Eastern European countries(the Czech Republic, Hungary and Poland).

Apart from the amount of ODA provided to developingcountries as a group, it is also worth looking at the desti-

nation of ODA. Most of European donors focus on sub-Saharan Africa, whereas other donors (Australia, Cana-da, Japan, New Zealand, the United States, but also Ger-many and Spain) focus more on the Pacific region (Asia,Latin America, and Pacific). This regional orientation re-sults in a higher proportion of aid being allocated bythese donors to middle-income than is the case for mostof the EU donors (OECD, 2002). Overall, two thirds ofODA flows (close to USD 40 billion) go to 88 develop-ing countries that appear to be ‘on track’ to halve povertyby 2015 compared to 1990 levels (one of the develop-ment goals endorsed by the UN General Assembly). Theremainder goes to 55 developing countries, mostly LD-Cs, that are struggling to reach the international develop-ment goals and for which more aid would make asubstantial difference. Recent World Bank estimates (3)show that, irrespective of the 0.7 % overall target, cur-rent levels of ODA would need to be doubled in order tohelp low-income countries to reach their 2015 develop-ment goals.

The European Union is one of the major actors in inter-national development cooperation. Whereas the Europe-an Commission and the EU Member States togetherprovide about 50 % of world aid, the European Commis-sion alone provides some 10 % of the entire world aid.Its aid programme has continued to grow over a periodduring which many other donors’ programmes have de-clined. The total share of European aid managed by theCommission has gradually increased from 7 % 30 yearsago to 17 % today.

Starting from a programme that originally includedmainly Africa and few more countries in the Pacific andCaribbean (ACP countries), the European Commissionhas become global in its reach. New agreements, whichgo far beyond the traditional development aid, have beensigned to cover Asian and Latin America developingcountries (ALA programme), for the implementation ofthe Euro-Mediterranean partnership (MEDA pro-gramme), for the cooperation with the central and eastEuropean countries and the New Independent Statessince 1990 (Phare and Tacis programmes), and more re-cently specifically for the Western Balkans (CARDS).

EC external aid has also become more varied in nature.The vast bulk (some 90 %) of EC aid is grant aid, with lessthan 10 % provided as concessional loans. Hard loans,

¥1∂ Pearson (1969).¥2∂ See also conclusions of the Development Council of Ministers in Novem-

ber 2001. ¥3∂ IMF and World Bank (2001b).

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such as some European Investment Bank lending havealso been provided, but these are not included in the ECaid budget. Exceptionally, macro-financial assistance hasbeen provided which took most often the form of loans butincreasingly also a combination of grants and loans. Un-der the former Lomé Convention, the traditional forms ofassistance to ACP countries (financial and technical coop-eration) were joined by new aid instruments such as Sta-bex (system to stabilise export earnings) and Sysmin (thespecial facility for the mining sector). The new CotonouAgreement signed in June 2000 recognises the vulnerabil-ity resulting from high dependence on export earningsfrom the sectors of agriculture and/or mining and foreseesadditional support in case of serious falls in export earn-ings. In the new system, vulnerable ACP countries will beassisted in the framework of the overall programmingprocess and in accordance with the country’s developmentstrategy priorities.

Over the past decades, the number of major donors hasincreased, and the number of bilateral and multilateral

agencies and non-governmental organisations have in-creased even more. According to the World Bank(2000), in the 1960s five donors — France, Germany,Japan, the United Kingdom, and the United Statesaccounted for some 90 % of donor assistance, whosecombined share declined to less than 70 % but was deliv-ered through a greater number of agencies. This develop-ment, on top of the absolute and relative decline in ODAis obviously a problem for recipient countries and callsfor donor coordination, specialisation and concentration.

The World Bank and the IMF are two main playersamong multilateral institutions, providing support to im-plementation of the development agenda of beneficiarycountries. Regional development banks (BAD, ADB,IDB, EBRD) coordinate closely their development as-sistance instruments with these two institutions. In termsof concessional flows by multilateral organisations overthe period 1994–98, IDA (World Bank group) accountedfor an average 33 %, the IMF for nearly 5 %, the UNagencies system for 17 %, with the European Commis-

Figure 9: Net ODA in 2000 , in % of GNI

Source: OECD (2002).

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sion accounting for 31 %. Concessional arms of regionaldevelopment banks (Inter-American DevelopmentBank, Asian Development Bank and African Develop-ment Bank) accounted together for 11 % of total flows.

A.1.2. Improving effectiveness and the quality of aid

The discussion on volume of aid has been paralleled bya discussion on the effectiveness of aid.

The 1998 World Bank’s ‘Assessing aid’ report, based ona series of econometric studies (1), showed that aidboosts economic growth and alleviates poverty only inthose countries that carry out sound economic policiesand has no measurable effect in countries with poor pol-icies. Sound policies include open trade regimes, fiscaldiscipline and avoidance of high inflation. The reportconcluded that a reallocation of aid to ‘good policy-highpoverty’ countries would increase the efficiency of as-sistance.

Other studies have qualified these results. The eco-nomic model underlying the World Bank study isfound to be rather sensitive to the choice of thevariables (2). Also, aid can have a positive impact oneconomic growth in countries with a poor policy envi-ronment as long as the aid to GDP ratio is not high (3).It has also been claimed that cutting off poor perform-ers from aid allocation may not always improve over-all aid effectiveness. Where poor performance iscaused by external shocks (e.g. terms of trade chang-es), continued assistance may prevent the country fromentering a lasting recession (4). Lastly, uncertainty inaid flows (deviations from expected inflows) may havea negative impact on the level of investment in a coun-try, which is in itself a principal determinant ofgrowth. When such uncertainty is controlled for, aidmay have a positive effect on growth even in a poorpolicy environment (5).

Conditionality and ownership

Most aid programmes are conditional upon the imple-mentation of certain policy reforms. However, it is in-creasingly accepted that the effectiveness of aid requiresa national commitment to the reform process and thateconomic reforms can be supported but ‘cannot be

bought’. This implies that the conditionality associatedwith adjustment lending is unlikely to stimulate reformsunless it is in line with the government’s own pro-gramme.

The criticism of conditionality dates back to the early1980s and stemmed from the fact that the results of thestructural lending were disappointing and in some caseswere even perceived as harmful to economic growth (6).The initial reaction of the donor community was to in-crease the number of conditions and to shorten the periodfor the execution of programmes so as to stimulate devel-oping countries to carry out the required reforms. Howev-er, recipient governments were unwilling to carry out thesereforms because the conditions were perceived as inappro-priate or as imposed without their direct involvement.

The perceived failure of conditionality led to a new em-phasis on ownership of the reform process by the recipientcountry’s government. The comprehensive developmentframework (CDF) was introduced by the World Bank inOctober 1998, and launched in January 1999, as a conceptfor a holistic approach to development. The CDF seeks abetter balance in policy-making by highlighting the inter-dependence of all elements of development: social, struc-tural, human, governance, environmental, economic, andfinancial. It promotes partnerships among governments,development-cooperation agencies, civil society, and theprivate sector. Of particular importance is the emphasis oncountry ownership of the development process. Withinthis framework, the World Bank and the IMF subsequent-ly launched in September 1999 the poverty-reductionstrategies (PRS) for low-income countries, to mainstreampoverty-reduction in government and donor policies, inparticular in those recipient countries that benefit from en-hanced debt relief within the HIPC initiative. In support ofthe PRS of IDA eligible countries, the World Bank has de-veloped the poverty-reduction strategy credit (PRSC) andthe IMF poverty-reduction and growth facility (PRGF) ar-rangements, successor to the ESAF (7).

The European Commission has also shifted from tradi-tional policy-based conditionality towards results-basedassessments and related aid disbursements. The new ori-entations in macroeconomic support therefore aim at in-creasing long-term sustainability of economic and social

¥1∂ Burnside and Dollar (1997) and Collier and Dollar (1999).¥2∂ Dalgaard and Hansen (2000).¥3∂ Hansen and Tarp (2000).¥4∂ Guillaumont and Chauvet (2000).¥5∂ Lensink and Morrissey (2000).

¥6∂ Killick (1998).¥7∂ Apart from greater ownership and poverty-reduction focus, fiscal targets

are more flexible, conditionality is more selective and there is moreemphasis on measures to improve public resource management, transpar-ency and accountability.

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reforms, fostering governments’ ownership of the pro-gramme and enhancing donor coordination. The degreeof implementation of the new approach varies amongcountries, according to the degree of achievements in de-veloping well-articulated and coherent PRSP documentsand establishing key performance-based indicators, aswell as the availability and quality of data, the institu-tional capacity for their collection and assessments andthe existence of a framework for improving public fi-nance management to ensure that budget funds — gov-ernment and donor alike — are properly spent and havemaximum impact. The pilot exercise on the reform ofconditionality carried out in Burkina Faso has been a keyelement for the Commission to set up these orientations.

At the same time, the Commission has launched a funda-mental reform of its external assistance, aiming to im-prove aid quality, cut implementation time, harmoniseand simplify aid management. In particular, the Com-mission has undertaken to strengthen the programmingprocess to ensure the consistency of strategies definedfor all the developing countries and introducing a proc-ess of deconcentration and decentralisation intended tobring decision-making closer to partner countries (1).

Policy coherence

Promoting coherence between development policies andthose of trade, security, investment, and the environmentcontinues to be a major challenge for international do-nors. Incoherence is often caused by conflicting interests(e.g., geopolitical concerns, economic interests, solidar-ity) among the multiplicity of actors involved in devel-opment at international level. Incoherence is also createdat national level within the agencies of donor govern-ments because of the plurality of decision-making bod-ies. Furthermore, in the past years, there has been aproliferation of items on the development agenda. De-velopment no longer includes only economic growth andelimination of poverty, but also gender equity, environ-mental sustainability, good governance, and respect ofhuman rights.

Within the OECD Development Assistance Committee(DAC), efforts are being made to promote policy coher-ence for development. For example, the DAC and theTrade Committee will undertake a ‘common reading’ ofthe Doha ministerial trade conference outcome and, to-gether, assess its implications and directions for future

collaborative work on the development dimension oftrade. Also, the DAC Development Partnerships Forumbrings together different OECD policy communities, de-veloping country and private-sector stakeholders to dis-cuss how to attract private finance in the developmentprocess. These examples illustrate the ‘two-way street’approach to promoting policy coherence, which goes be-yond integrating the development dimension in the workof other policy communities, but also looks to integratethe policy findings of those communities into DACwork.

The Treaty on European Union contains several refer-ences to policy coherence. The aim is that consistency ofEU external activities as a whole be ensured in the con-text of its external relations, security, economic and de-velopment policies. The Council, Commission andParliament all bear responsibility for increasing the levelof coherence of policies that have or may have a bearingon the Union’s external performance. Ideally, the differ-ent EC and also Member States’ policies should fit to-gether, complement each other, and create positivesynergetic effects. As a minimum, it should be ensuredthat these policies, and the activities implemented in thecontext of these policies, do not contradict or workagainst each other. The challenges are well-known — in-cluding the effects of trade, agriculture and fisheries pol-icies on developing countries — and have been part ofthe development-policy discourse for many years, andthe efforts to integrate trade in development policy are anexample of the pursuit of policy coherence.

Untying of aid

One of the most extensively discussed cases of policy in-coherence is tied aid. The question is whether aid shouldbe freely available to buy goods and services from allcountries (untied aid) or whether aid should be restrictedto the procurement of goods and services from the donorcountries (tied aid). One of the rationales of tied aid is to‘buy political support’ for development policy at home,by benefiting domestic companies through public pro-curement.

In May 2001, donors have reached an agreement on a DACrecommendation to untie ODA to the least developedcountries (2). The recommendation also acknowledges thatdifferent approaches are required for different categories of

¥1∂ See European Commission (2001).¥2∂ DAC recommendation on untying official development assistance to least

developed countries, OECD, May 2001.

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ODA and that actions to implement the recommendationmight vary among donors in terms of coverage and timing.It should be noted that the recommendation only concernsthe LDCs, which may not have the full supply capacity ofpublic procurement; also, the recommendation does notcover technical cooperation, nor food aid.

The EU has accepted to implement the DAC recommen-dation on the untying of aid to LDCs and several Mem-ber States are in the process of untying their bilateral aidbeyond the scope of the recommendation. The Commu-nity has identified the measures necessary to implementthe recommendation and will set in motion the necessaryprocedures. The Commission’s intention is to go further,with the support of Member States, e.g. through the revi-sion of the ALA regulation, and to prepare a communi-cation that would propose implementing the DACrecommendation through all its aid instruments. Thatwould, in the case of the Cotonou Agreement, also re-quire the consent of the ACP partners.

Coordination and complementarity

The fragmentation of aid and poor coordination has beena major obstacle to aid effectiveness. If better policy per-formance in recipient countries is important, likewise do-nors should do more to ensure the effectiveness of aid.The inefficiency that arises from lack of donor coordina-tion is an old, but still unresolved problem. Some attributethis lack of coordination to the recipients’ lack of absorp-tive capacity, others to the different objectives that drivedonor programmes and again others to the multiplicity ofaid agencies, each pursuing their own priorities (1).

All donors recognise the importance of partnership to ad-dress development more effectively. From the start of2000, country-led poverty-reduction strategies (in thelight of the World Bank’s Common Development Frame-work) have provided a common ground for improving do-nor action at country level in many of the poorestcountries. At sectoral level, the focus has been on harmo-nisation of operational policies and procedures in and be-tween multilateral and bilateral agencies, which shouldeventually contribute to a decrease in the transaction costsof international ODA. Despite talk of better harmonisa-tion, practice lags behind. An important immediate step isthe sector-wide approach, by which financing is providedto an investment programme for a selected sector in its en-

tirety, based on an evaluation of that sector’s policyframework and institutional strengths. Although progresshas so far been limited, an important learning process isongoing (World Bank, 2001a).

As far as the EU is concerned, the Treaty establishes thatthe Community and the Member States shall coordinatetheir development-cooperation policies and consult eachother on their aid programmes, including in internationalorganisations and during international conferences.Strengthening complementarity and moving towards a di-vision of labour between the Community and the MemberStates is one of the principles agreed in the new policyframework adopted by the Council and the Commission.The concentration of Community activities in a morelimited number of areas where it can make a special con-tribution and can have an added value to that of other de-velopment partners, and in particular the EU MemberStates, is fully consistent with this approach. The Counciland the Commission have identified the following six pri-ority areas: link between trade and development; supportfor regional integration and cooperation; support for mac-roeconomic policies and promotion of an equal access tosocial services (education and health); transport; food se-curity and sustainable rural development; institutionalcapacity-building, particularly in the area of good govern-ance and the rule of law.

Concessionality

There is an ongoing discussion on increasing the share ofdevelopment funding in the form of grants rather than con-cessional loans, as a way to better target poverty reductionand to prevent accumulation of unsustainable debt burdens.

This also affects IDA, the concessional arm of WorldBank lending, which is currently discussing its 13threplenishment (2). Various alternatives are being as-sessed for the possible introduction of grants into IDAschemes (3). These range from providing up to 50 % ofIDA resources in the form of straight grants for IDA-only countries (i.e. equivalent to 40 % of all IDA13 funds), to limiting to 5–10 % such expansion ofgrants. Also, a possible differentiation within IDA-onlycountries is considered, with very poor countries being

¥1∂ Cassen et al. (1994), Alesina and Dollar (1998) and Kanbur and Sandler(1999).

¥2∂ IDA donors get together every three years to discuss IDA replenishments;the current IDA 13 concerns fiscal years 2002–05.

¥3∂ ‘Grants in IDA’, IDA, September 2001, available on the Internet (http://www.worldbank.org/ida/ida13docs.html).

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given the highest level of concessionality, as well aspost-conflict/post-disasters countries.

While the introduction of grants could change the natureof IDA, and thus raise fundamental questions, it also hasimplications in terms of financing. Given that loan re-payments from IDA credits contribute to around 40 % toIDA replenishment, the introduction of grants will in-volve a cost in terms of foregone re-flows. This entailsthat either more resources from donors would be needed,or more grants to poorer countries would result in hard-ening terms for less poor IDA borrowers. These ongoingdiscussions have also led to explore other routes forproviding increased concessionality, such as extendedmaturities, the abolition of the service charge in conces-sional loans (currently at 0.75 % of disbursed balances),and the extension of the grace period.

A.2. Debt reduction

The debt of developing countries continuously increaseduntil the mid-1990s despite repeated debt-relief actionsprovided by official and private creditors. This accumu-lation of debt not only prevented the debtors from facingup to their repayment obligations but also further ham-pered their development.

According to the debt overhang theory (1), excessivedebt burdens divert resources from key productive in-vestments and discourage policy reforms which couldpromote growth. They constrain the ability of indebtedStates to finance basic expenditure, e.g. in the areas ofeducation and health. This is particularly true for highly

indebted poor countries, which need to target expendi-tures towards poverty reduction.

Debt relief lowers the budgetary resources tied up in debtservicing and, if accompanied by the right economic pol-icies, should contribute to creating a more stable macr-oeconomic environment with lower interest and inflationrates conducive to saving, investment and sustainablegrowth. It should also allow the country to increasebudgetary spending in social sectors, assuming that debtrelief is not accompanied by a reduction in ODA.Through a reduction of the debt burden to a sustainablelevel, domestic and foreign private investment is likelyto increase, as potential investors will be less concernedabout higher taxes (including inflation) which could beimposed in the future to pay off the debt (2). The reduc-tion will also increase the chances that the portion of thedebt that remains outstanding will be repaid, which isbeneficial for the creditor (and may in some cases evenoutweigh the cost of debt reduction). Finally, debt reliefmay improve the quality of the dialogue between the do-nors and the beneficiary countries, as it will refocus thediscussion on priorities and reduce the preoccupationwith the terms of refinancing the old loans.

A.2.1. Trends and figures

Following a sharp rise in the 1970s which multiplied thedebt stock by a factor of 8, the overall stock of externalpublic debt of developing countries continued to rise,from USD 377 billion in 1980 (at the beginning of thedebt crisis) to more than USD 1 600 billion in 1998. Itdecreased slightly in 1999 and 2000 (Table 3).

At the same time, the debt of the 42 heavily indebtedpoor countries (HIPCs) increased from about USD 60billion in 1981 to more than USD 180 billion in 1995,

and declined somewhat afterwards to about USD 170billion in 1999. Relative to GNP, the debt of developingcountries doubled from 18 % in 1981 to 37 % in 2000.

¥1∂ See e.g. Claessens et al., (1996). ¥2∂ World Bank, (2001a).

Table 3

External public debt of developing countries, in billion USD

1970 1980 1990 1995 1996 1997 1998 1999 2000

Multilateral (incl. IMF) 8 61 242 356 345 353 420 424 410

Bilateral 26 127 397 566 543 529 527 533 512

Private 14 189 510 588 569 609 676 665 669

Total 48 377 1 149 1 510 1 457 1 490 1 623 1 621 1 591

Source: World Bank, Global Development Finance.

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Over the same period of time, the debt to GNP ratio ofHIPCs rose from about 50 % in 1981 to a level of 110 %in 1999, having peaked at more than 160 % in 1994.

According to Daseking and Powell (1999), factors con-tributing to the substantial rise in external debt in the1970s and the 1980s included adverse terms of tradeshocks, a lack of sustained adjustment, structurally weakdebt management practices and political factors. Theyalso emphasise ‘national interest’ lending which sug-gests that, from the creditor government perspective, themotivation for a significant share of commercial lendingor guaranteeing of loans to low-income countries wasthe stimulation of their own exports.

For developing countries in general, private creditorshave been the largest creditor group over the last 20years (followed by bilateral and multilateral creditors),even if their share decreased from about 50 % in the1980s to slightly more than 40 % in 2000. For theHIPCs, bilaterals have always been the largest creditors,followed by the multilaterals and, far behind, privatecreditors. For the group of 24 HIPCs benefiting from in-terim debt relief, the multilaterals have become the maincreditors, with a share of 40 % of total debt outstandingin 2000. Claessens et al. (1996) underlined that creditorsof the HIPCs are mainly official creditors (bilateral andmultilateral) rather than private commercial creditorsand that their primary objective was not profit maximi-sation, but that they had a set of more complex goals. Itwas therefore argued that the conventional approach foranalysing debt issues needed to be adjusted to the specif-icities of these countries.

A.2.2. Debt-reduction mechanisms

Where several players are involved (which is usuallythe case), debtors and creditors have generally found itpreferable to reschedule debt in a concerted framework(Abrego and Ross, 2001). Such concerted action ad-dresses the free-rider problem according to which cred-itors may try to avoid providing debt relief but wouldnevertheless profit from improved debt servicing ca-pacity of a debtor country, once debt relief has beengranted by others (see also Claessens et al.). This free-rider problem applies both within creditor groups (e.g.between different official creditors) and between dif-ferent creditor groups (e.g. official versus private cred-itors). Another advantage of concerted action is that thenegotiated agreement is generally based on a commonframework and a common set of conditions, such asthose defined in the context of an IMF programme.

Such a framework increases substantially the likeli-hood that the debt relief will have a lasting positive im-pact on development (1).

Paris Club

The Paris Club of official creditors (2) provides a frame-work for rescheduling, on a case-by-case approach, ofsovereign-to-sovereign debt (publicly owed or guaran-teed, with medium- and long-term maturities). Fulfil-ment of IMF conditionality and consensus betweencreditors are sine qua non conditions for reaching a debt-relief agreement. Until 1987, Paris Club rescheduling in-volved mainly cash flow relief, which contributed to acontinuous rise in debt. Creditors believed that the debt-service problems of the poor countries would only betemporary. While private creditors had typically reducedtheir exposure in these countries and cut their losses inresponse to their customers’ payment difficulties, offi-cial creditors provided comprehensive non-concessionalflow rescheduling in the context of the Paris Club underthe so-called ‘classic terms’.

In the second half of the 1980s, it became clear thatlow-income countries (LICs) were facing solvencyproblems that required not only a temporary debt relief,but also a reduction in the level of debt. In 1988, the To-ronto G7 summit adopted a compromise, leading to areduction of one third of the NPV of the LICs outstand-ing debt, including for the first time commercial exportcredit agency debt. The Toronto terms were granted to20 LICs by the Paris Club until 1991 (3). They weresubsequently replaced successively by other terms withincreasing NPV reductions (4), ending with the Co-logne terms in 1999 providing a 90 % reduction- ormore if necessary — in the context of the EnhancedHIPC initiative (Cologne terms).

HIPC initiative and enhanced HIPC initiative

The HIPC initiative, launched in 1996, started to deal withthe debt burden owed to multilateral institutions, rather

¥1∂ Daseking and Powell (1999).¥2∂ The Paris Club, which was active for the first time in 1956, includes 19

permanent member countries.¥3∂ As far as the (highly indebted) lower middle-income countries are con-

cerned, the Paris Club creditors began in 1990 to grant them concessionaldebt reduction (for ODA only) in the form of flow rescheduling (Houstonterms).

¥4∂ From 1991 London terms (up to 50 % reduction of the NPV of the LICsoutstanding debt); from 1994 Naples terms (up to 67 % on both ODA andnon-ODA credits to HIPCs); from 1996 Lyon terms (up to 80 % of NPVdebt reduction to countries qualifying for the HIPC initiative).

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than merely concentrating on bilateral debt (1). Its principalobjective is to bring the poorest countries’ debt burden tosustainable levels, subject to satisfactory policy perform-ance, so as to ensure that adjustment and reform efforts arenot put at risk by continued high debt and debt-service bur-dens. It has been underlined repeatedly, however, that theachievement of this goal will depend on whether or notfunding used by the donor countries to finance the debt re-lief is obtained by cutting other forms of aid.

Soon after the approval of the original HIPC initiative,doubts were expressed by NGOs and academic circleswhether the debt relief envisaged was far-reachingenough. Criticism not only focused on the extent of debtrelief and the targeted sustainability level (with obviousimplications for the number of countries supported underthe initiative) but it also questioned the wisdom of waitinguntil the completion point before debt relief is granted.This condition aimed to create a satisfactory track recordto increase the chances that the debt reduction would havethe desired positive effects on development and alsoaimed to address the moral hazard problem (2).

In 1999, following pressure from NGOs and the devel-opment community, the HIPC initiative was enhancedto provide ‘deeper, broader and faster’ debt relief tothose countries pursuing reform and povertyreduction (3). One of the major challenges, from thecreditors point of view, has been to find the necessaryresources to finance the increase in the costs resultingfrom the enhancement of the HIPC initiative. In orderto finance the participation of the multilateral institu-

tions in the initiative, a Trust Fund, managed by theWorld Bank, was established.

Out of the 42 identified HIPCs, 24 countries have so farreached the decision point — when the debt relief is ap-proved and interim relief begins — and four countrieshave reached the completion point — when the remain-ing amount of relief is committed irrevocably (4).

The EU has been a major player in the HIPC initiative.The Community, as a creditor (5), has so far decided tocontribute to the HIPC initiative for a total amount ofEUR 360 million (40 under the original and 320 underthe enhanced initiative, all in favour of ACP countries).As a donor, the Community will contribute to the en-hanced initiative for a total amount of EUR 734 million(680 for ACP countries, 54 for non-ACP countries) (6).As far as the implementation is concerned, the Commu-nity has already transferred EUR 304 million to theHIPC Trust Fund managed by the World Bank (7). As acreditor, there have been some delays in implementa-tion, essentially due to the Commission’s internal re-form and delays by recipient countries to respond toproposals of action. So far, the Community has provid-ed grants for debt alleviation in favour of Uganda, Guy-ana, Burkina Faso and Mozambique, totalling aboutEUR 38 million.

London Club — Brady Plan

As far as private creditors are concerned, the London Clubprovides a framework allowing debtor countries to restruc-ture their debts owed to commercial banks, which is re-quired by the Paris Club under the ‘comparable treatment’clause (8). Unlike the Paris Club, where the agreement withthe debtor has to be unanimously approved, the negotiatedagreement within the London Club needs approval ofbanks holding 90 to 95 % of total exposure. Since there isno legal possibility to force dissident creditors to accept the

¥1∂ The HIPC debt initiative is open to the poorest countries, those that: (i) areeligible only for highly concessional assistance such as from the WorldBank’s International Development Association (IDA) and the IMF’s Pov-erty Reduction and Growth Facility (PRGF); (ii) face an unsustainabledebt situation even after the full application of traditional debt relief mech-anisms (including Paris Club agreements); and (iii) have a proven trackrecord in implementing strategies focused on reducing poverty and build-ing the foundation for sustainable economic growth. Under the enhanced framework, a country’s debt is deemed unsustainableif the ratio of the net present value of external debt to export exceeds150 % (see http://www.worldbank.org/hipc for more details).

¥2∂ Providing debt relief to those that are running bad policies while not sup-porting those that have been able to avoid a debt problem through seriousadjustment and cautious borrowing practices may induce policy-makers toopt for the wrong policies (see e.g. Claessens et al.)

¥3∂ ‘Deeper’ means that the relief would cut deeper into the debt by loweringthe target sustainability ratios in order to ensure a permanent exit from thedebt problem. ‘Faster’ means that the so-called completion point underwhich full debt relief can be delivered can be reached earlier than the nor-mal six-year period of performance required under the original IMF/WBsupported programmes and during which countries had to implement awide range of reforms in a satisfactory way. These modifications alsoresulted in the expected debt relief being ‘broader’ by expanding the likelynumber of countries becoming eligible.

¥4∂ Under the original framework, six countries (Uganda, Bolivia, BurkinaFaso, Guyana, Mali and Mozambique) had already reached their decisionand completion points.

¥5∂ The outstanding claims that the Community has on the HIPC’s concernmainly the so called special loans, which were granted to the ACP coun-tries in the 1970s and 1980s, and risk capital loans managed by the EIB.

¥6∂ Council Decision 98/453/EC of 6 July 1998 and ACP–EC Council of Min-isters Decision 1/1999 of 8 December 1999.

¥7∂ EUR 10 million dedicated to Guyana (the sole non-African ACP country),EUR 240 million dedicated to African ACP countries, and EUR 54 milliondedicated to Asian and Latin American countries.

¥8∂ Given that there are generally more creditor commercial banks than credi-tor governments, a committee of about 15 banks is generally designated bythe London Club to negotiate with the debtor. An active IMF agreement isa prerequisite for such negotiations.

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negotiated agreement, and given the usually large numberof creditors concerned, a minority of them can delay theprocess for years (1). Results of negotiations may varyfrom debt rollover to significant write-down.

The Brady Plan launched in 1989 offered creditor com-mercial banks the choice between providing new moneyor accepting a debt stock. The commercial banks gener-ally chose the second option, where the principal andsome of the interest of loans would be guaranteed withUS Treasury bonds in exchange for a write-down of theamounts outstanding. Although the Brady Plan has ben-efited 15 middle-income countries and no poor coun-tries, the experience may contain useful lessons for othercountries, such as the importance of implementing mac-roeconomic stabilisation and economic reforms prior todebt reduction (Claessens et al., 1996).

A.2.3. Continued debate

Whereas there seems to be a consensus that the enhancedHIPC debt relief is an improvement compared to theoriginal initiative and earlier actions, there is an ongoingdebate on whether the current action of creditors is suf-ficient to address the problems of the poorest countries.

Impact and additionality

According to recent analysis, the cumulative debt reduc-tion provided by the Paris Club and multilaterals to thegroup of 24 HIPCs having already reached their decisionpoint should attain 64 % (expressed in 1999 NPV terms),which sounds impressive (2). In NPV terms, this is expect-ed to deliver USD 20.3 billion, including USD 10.6 bil-lion provided by multilateral creditors, while all HIPCsare expected to be granted a total of USD 29.3 billion.

However, Cohen (2000) argues that the type of calcula-tions made above grossly overstate the benefits for therecipient country implied by the debt reduction. He esti-mates the average price of HIPC debt to be at 28 %, butthe marginal value of the debt (indicating the degree towhich they will actually benefit from a certain amount ofdebt reduction) at only 10 %. While recognising that theenhanced HIPC initiative ‘is clearly more generous, as itreduces the debt down to a point where the effect can befelt’, he calls for more transparency (through reportinglosses of about 90 % and the granting of actual debt re-

lief for the remaining part). He argues that donor coun-tries would as a result be less tempted to scale downODA in line with debt relief and more inclined to respectthe principle of additionality, which is necessary to en-sure that the debt initiative has an overall positive impacton the country concerned. The concern about additional-ity is more generally shared (see also World Bank,2001a; Jubilee+, 2001; Eurodad, 2001a).

Debt sustainability and the poverty link

It has been questioned whether the HIPC initiative will in-deed ensure debt sustainability. The General AccountingOffice of the US Congress (2000) as well as a number ofNGOs (3) have argued that the calculated debt sustainabil-ity levels are still too high. The difficulty of basing debt re-lief on highly volatile export earnings (determined amongother things, by world growth, terms of trade and marketaccess) has been addressed, at least partially, by the recentagreement by the International Monetary and FinancialCommittee that from now on each HIPCs debt sustainabil-ity is assessed at its completion point. This allows for thepossibility of providing additional debt relief for thosecountries for which the debt situation has worsened due toexceptional factors which include bad growth perform-ance and deteriorating terms of trade.

Others question whether the debt-to-export ratio is the ap-propriate criterion to judge sustainability. For example,Cohen (2000) presents econometric results that suggestthat the debt-to-tax ratio would be a more appropriate pri-mary indicator for assessing debt sustainability than thedebt-to-export ratio. Sachs (1999) argues that the debt-to-export ratio ignores the fact that ‘debts were owed by gov-ernments, not exporters’, and that the ratio of debt to ex-ports could conceivably measure the trade-offs betweendebt servicing and meeting basic human needs. He pro-poses that the cost of basic social needs and a govern-ment’s capacity to pay have to be better taken intoaccount, adding that the net resource transfers of highlyconcessional assistance have to be increased to finance thebudget rather than off-budgetary programmes (4).

NGOs argue along similar lines, underlining that eventhe enhanced HIPC initiative is not sufficiently contrib-

¥1∂ Radelet (1999).¥2∂ World Bank (2001c).

¥3∂ Jubilee +2000, Eurodad.¥4∂ At the same time, he advocates a cancellation of debt servicing on old

debts. According to Sachs, debts owed to bilateral creditors, IBRD andIMF should be forgiven, while IDA would need to be only forgiven in caseIDA debt servicing was imposing large net resource costs on a particularcountry.

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uting to poverty reduction (1). They suggest to base theassessment of debt sustainability on poverty reduction:budgetary resources would be reserved, in a first stage,for expenditures which are necessary to fight poverty(such as education, health and basic infrastructure); in asecond stage, to service the domestic debt; and only in athird stage to service the external debt. The size of thepoverty-reducing expenditures would be derived fromthe country-owned PRSPs.

From this perspective, any low-income country that suf-fers from high-level indebtedness coupled with low gov-ernment revenues and widespread poverty would beeligible for a debt-relief initiative. But by putting debt re-payment as the last priority of expenditures, the benefi-ciary countries might have more difficulties in gaininginvestor confidence and financial market access. Moreo-ver, this proposal raises the important issue of the avail-ability and the programming of resources to finance thedebt relief as well as the moral hazard issue.

In this context, it is also worth mentioning that accordingto the World Bank, social expenditures in the 24 enhanceddecision point countries are estimated to have increasedby an average of USD 1.7 billion during 2001–02 (2). Atthe same time, it is worth noting that systems that track theexecution of overall spending on poverty-related pro-grammes need to be further developed.

Irrespective of other ongoing debates, it is generally rec-ognised that the beneficiary countries have a very impor-tant responsibility in pursuing the right policies, in theframework of a well designed PRSP which will deter-mine the future trend of economic growth and new exter-nal borrowing and therefore ultimately its long-term debtsustainability. The balance between conditionality (trackrecord of good policies) on the one hand and poverty fo-cus and immediate relief on the other has been shifted to-wards the latter through the Enhanced HIPC initiative,but not all would agree that this shift has been sufficient.

In this context, it is important to note that several creditorcountries have decided to cancel the total of their eligibleclaims towards HIPC countries. Also, at the initiative ofthe Commission, the Council decided in May 2001 to al-leviate all special loans granted to least developed ACPHIPCs that would remain after the full implementation

of the enhanced HIPC initiative. This decision, whichhas been endorsed by the Joint EU/ACP MinisterialCouncil, would lead to a further EUR 60 million debt re-lief.

Is the HIPC initiative reaching a sufficient number of countries?

The question whether the HIPC initiative is making asufficient impact on the world debt and development sit-uation is not only raised with regard to those countriesthat are expecting to receive debt relief under presentmechanisms, but also regarding those that may not ben-efit under current circumstances.

A first group to consider is the countries in conflictwhich are in principle eligible for the HIPC initiative buthave not qualified yet. Out of the 14 countries whichhave so far not yet benefited from debt reduction in thecontext of the HIPC initiative, nine countries are consid-ered as conflict- affected. There is a common under-standing on the need to facilitate HIPCs emerging fromconflict crisis to qualify for debt relief and the initiativehas been taken by the G7 to reinforce the political dia-logue with these countries. On the other hand, it is diffi-cult to conceive fast-tracking of debt relief for regimesengaged in acts of aggression or internal repression (3).

A second consideration is to review whether it may bepossible to make more countries than the 42 HIPCs qual-ify for HIPC or other debt relief. This issue has receivednew impetus following the 11 September events whichhave raised the question to what extent impoverishedcountries provide a breeding ground for terrorism. Onepossibility may be that in the light of the latest events andthe slowdown of growth more countries may qualify forthis or other debt relief. The other option would, ofcourse, be a review of the level and nature of the eligibil-ity criteria which is linked to the sustainability discus-sion referred to above.

The financing issue

Obviously any idea to provide deeper or broader debt re-lief meets with very important financing constraints. Itwas already difficult to mobilise the financing for the en-hanced HIPC initiative (especially for multilaterals suchas the African Development Bank). Moreover, there is apossibility that the recent slowdown in growth and the de-

¥1∂ Eurodad (2001a).¥2∂ World Bank (2001c). ¥3∂ See also Group of Seven (2001a).

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cision to make an analysis at the completion point couldimply further costs. On the other hand, there seems to besome consensus that the current debt situation of develop-ing countries is not only the result of bad policies in thosecountries. Against this background, any examination ofthis question will obviously have to weigh, in a compre-hensive and forward-looking way, the global costs of apossible perpetuation of the debt problem against the costsof providing additional relief (which would obviouslyhave to also be addressed in a comprehensive way).

A.3. Integration into the global trade system

Efforts to integrate developing countries into the globaltrade system and other development-oriented policies, inparticular ODA should be seen as complementary as-pects of an overall strategy towards sustainable globaldevelopment, and more specifically targeting economicgrowth and poverty reduction. Several studies haveshown that there are links between trade, developmentand poverty reduction.

Firstly, there is an acknowledged positive relationshipbetween trade and economic growth (1). Secondly, thereseems to be a positive relationship between growth andreduced levels of poverty. Growth tends to benefit allsectors of society ‘raising all boats’ and thereby bringingthe poor above the poverty line. There is clear evidenceof such an effect in East Asia, where six out of 10 wereliving on under USD 1 a day in the mid-1970s, while to-day it is two out of 10, and where, beyond conventionaleconomic indicators, other indices of development suchas literacy, life expectancy, and levels of political libertyhave also shown an upward trend.

Establishing a direct link between trade and poverty re-duction is more complex. Several studies have found anempirical positive relationship between trade openness,growth and poverty reduction (2). However, others havequestioned the robustness of such studies, particularlythe appropriateness of the indicators used for openness(Rodrik, 2000). These criticisms highlight the difficultyin proving the empirical link conclusively through cross-country empirical analysis in a context where so manyother factors are at work. In addition, they indicate theimportance of adopting sound economic policies and

flanking measures to help ensure that the economic anddevelopment benefits of trade openness can be realised.

Moreover, there is some evidence that the poorest sec-tions of the population may be the most vulnerable toshort-term restructuring costs of trade opening, particu-larly terms-of-trade changes or higher volatility (3). In-creased openness may also reduce the capacity ofprotecting strategic industries, as well as increase therisk of anti-competitive behaviour by large foreigncompanies (4). These potential negative effects must beanticipated and appropriate policies adopted in tandemwith liberalisation if the positive impacts of openness areto be felt throughout the population.

Although there is extensive debate on the extent towhich openness stimulates poverty reduction, there isless controversy on the fact that it has a role. Few econ-omists would now argue that closed economies fostergrowth and, indeed, there are no examples of closedeconomies that have shown sustained rapid growth.Therefore, it appears that trade openness is a necessary,but not sufficient, condition for growth and poverty re-duction, as well as being to some degree an outcome ofthem. To ensure a positive impact, additional policies,including sound social and economic policies, regula-tory frameworks conducive to trade and investment andadequate re-distributive and retraining policies are re-quired.

In many developing countries, domestic reform and in-creased trade liberalisation will not be adequate to en-sure extensive increases in exports. Trade-relatedtechnical assistance and capacity-building are importanttools to help countries make use of the opportunities fortrade-based growth. Many countries simply lack the ad-ministrative capacity to fulfil the various requirements(e.g. health and safety standards, rules of origin, intellec-tual property rights protection) for market access, prefer-ential or MFN-based (most favoured nation).

A.3.1. Trends in trade

If oil trade is excluded (where exports have fallen sig-nificantly in dollar terms) developing countries havemade significant gains in recent years and are thus, at ageneral level, more integrated into the world economy(see Figure 10). In the past decade, the share of devel-

¥1∂ Dollar (1992), Sachs and Warner (1995), Edwards (1997).¥2∂ See, for example, Dollar and Kraay (2001).

¥3∂ Lundberg and Squire (1999).¥4∂ McCulloch et al. (2001).

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oping countries in global non-energy exports rose byalmost 7 %, reaching 25 % in 1999, while their shareremained stable at around 39 % in total exports includ-ing energy (World Bank, 2002a). This rise was mainlydue to manufactured goods, whose share of developingcountries’ exports increased from 25 % in the early1980s to 70 % in 1999. Developing countries are inparticular exploiting their comparative advantage in la-bour intensive manufactures. Their share of world tradein these sectors rose by over ten percentage points inthe 1990s to 53 %.

One should, however, observe that these favourabletendencies are highly concentrated in the emergingmarket economies such as Mexico, Chile, Brazil, Chi-na, Taiwan China, Malaysia and Thailand. Virtuallyall the least developed countries are not part of thistrend.

Exports to the EU have shown strong growth. The EU isthe main trading partner for much of the developing

world: more than half of developing countries exports tothe Triad (1) go to the EU, with which developing coun-tries as a group are now in surplus (Figure 11). In 2000,developing countries accounted for 42 % of extra-EUimports.

A.3.2. The challenges of integration

The main tools for fully integrating developing countriesinto the global trade system, and thereby enabling sus-tainable development, are trade liberalisation, trade-re-lated capacity building and accompanying policies. Eachof the three aspects requires action at international anddomestic levels, by developed and developing countriesalike.

¥1∂ Triad refers to the three largest trading powers; i.e., the EU, the UnitedStates and Japan.

Figure 10: Developing countries’ exports by sector (billion EUR)

Source: UN Comtrade database.

Manufactured products

Agricultural prod.

Energy & other products

0

200

400

600

800

1 000

1 200

1 400

1980 1985 1990 1995 1999 2000

Bill

ion

EU

R

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Trade liberalisation

Improved market access has the potential to bring majorwelfare gains, especially to the developing world. A re-cent study by the World Bank (2001a) considered theimpact of full trade liberalisation (an admittedly unlikelyimmediate prospect) and concluded that developingcountries would see increases in welfare of up toUSD 539 billion per year if dynamic impacts on produc-tivity are taken into account. A major part of this gain isdue to reductions in developing countries’ own protec-tive tariffs. This lowers import prices for consumers andfor producers using imported intermediate goods and en-courages the re-allocation of domestic resources towardsproduction in sectors in which developing countries havea comparative advantage.

Developing countries’ exports still tend to be disadvan-taged as regards market access, at least if one regardsMFN tariff rates only. Their tradable output often has ahigh component of agricultural and labour-intensivemanufacturing goods (such as textiles). These goods of-ten face the highest trade barriers in developed countrymarkets as well as in neighbouring regions. The WorldBank has calculated that exports of agricultural and la-

bour-intensive manufactures face tariffs of, on average,twice the level of other goods. Figure 12 shows that thehighest rates are still in developing countries, but devel-oped countries also practise tariff escalation (1).

Reducing tariff peaks and tariff escalation is thereforeimportant to increased market access. In the case of non-agricultural products, this is indeed an agreed objectivefor the trade negotiations in the WTO that were launchedat the fourth WTO ministerial conference in Doha in No-vember 2001. Developing and developed country hightariffs should be addressed in this context. In fact, mostof the welfare gains forecast by the World Bank comefrom the elimination of tariffs between developing coun-tries, rather than improved access to developed markets.

The impact of tariff peaks and tariff escalation in devel-oped country markets is to a large extent offset by pref-erential access, such as, for the EU, the GSP scheme,bilateral free trade agreements or the ACP–EU CotonouAgreement. The generalised system of preferences(GSP) provides preferential access to the EU market to

Figure 11: EU trade with developing countries (billion EUR)

Source: Comext database, Eurostat.

0

50

100

150

200

250

300

350

400

450

500

1995 1996 1997 1998 1999 2000

Mill

ion

EU

R

Exports Imports

¥1∂ Tariff escalation signifies that higher tariffs are applied to processed goodsthan to corresponding primary goods.

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beneficiary countries and therefore enhances their exportearnings, promotes their industrialisation and encourag-es the diversification of their economies. However, ifbeneficiary countries were better equipped to meet pro-cedural and technical requirements (e.g. sanitary andphytosanitary standards, customs and transport proce-dures, etc.) they could increase their utilisation rate andcompete more efficiently on international markets. Thenew EU GSP regulation, adopted in December 2001, forthe period 2002–04, further simplifies the rules and har-monises procedures making the instrument more user-friendly and effective. The unilateral EU ‘Everything butarms’ (EBA) initiative launched in early 2001 openedEU markets to all LDC exports, by allowing duty andquota free access. This market access should enablethem to exploit economies of scale to develop industrieswhich were previously unviable (1).

At the May 2001 third UN conference on LDCs, all in-dustrialised countries for the first time committed to theobjective of duty and quota free access for all exportsoriginating in LDCs. Such an emulation of the EU EBAby other major industrialised nations would contributesignificantly to LDCs’ opportunities for trade-based

growth (2). Studies of the impact of EBA have forecastlarge increases in welfare as a result — betweenUSD 400 and USD 317 million depending on thestudy (3). However, even prior to the adoption of EBA,levels of protection against LDC exports were far higherin other QUAD (4) countries than in the EU (Figure 13).Thus if all QUAD members were to adopt similar meas-ures, the welfare impact would be much higher(USD 1.8–USD 2.5 billion).

An equally important element for development is the lib-eralisation of trade in services. In contrast to removing orlowering tariffs at the border, this encourages and re-quires policy reform. Furthermore, restrictions on tradein services do not increase government revenues in theform of tariffs but raise the costs for consumers thus af-fecting the economy at large. In other words, increasingefficiency in the services sector would have direct wel-fare effects by reducing costs of services for consumersand governments alike. However, it should be borne inmind that effective services liberalisation (e.g. telecom-

Figure 12: Tariff escalation

Source: World Bank (2001b).

0

5

10

15

20

25

30

Developing High income Developing High income

Tar

iff

rate

(%

)

First stage Semi-processed Fully processed

Agricultural

Industrial

¥1∂ As the EBA only concerns LDCs which often have a very small productivecapacity, with a very weak exporting base, the overall effectiveness of theEBA on poverty reduction may be limited.

¥2∂ The EU was the major destination for LDCs’ exports even before EBAwas adopted. In 1998, the EU accounted for 56 % of their total exports.Moreover, the EU already had very low tariffs for LDC imports; exports ofthe main products liberalised by the EBA were, however, very low. Elimi-nating protection will certainly enhance trade in the products concerned.

¥3∂ Unctad (2001), Ianchovichina et al. (2001).¥4∂ The QUAD comprises the EU, the United States, Japan and Canada.

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munications liberalisation) may involve costs to the do-mestic government in the form of establishing effectiveregulatory agencies.

Improved market access is a prerequisite to increasetrade and hence trade-generated growth. Trade liberali-sation, including in sectors of interest to developingcountries, and underpinned by stronger and more trans-parent multilateral rules, will be pursued in the context ofthe WTO trade negotiations, launched at the fourth WTOministerial conference under the Doha DevelopmentAgenda (see Box 2).

The effect of non-tariff measures on developing countryexports is also important. In particular technical stand-ards (TBT) and standards applied for health and safetyreasons (SPS) can significantly impact the export oppor-tunities of developing countries. While this is an issuethat will require increased attention over the comingyears, it is clear that the answer does not lie in a loweringof justified standards. Key instruments to help countriesmeet standards include support for their participation ininternational standard-setting bodies and capacitybuilding directed at relevant public and private-sectoractors. Similar challenges exist in the context of rules onintellectual property (the TRIPS Agreement), where sup-

port is vital to countries lacking domestic capacity to im-plement the agreement.

In the agricultural field, there is an evident need to re-duce trade-distorting domestic support including allforms of export subsidies and to improve market accessto address developing countries’ interest in special anddifferential treatment, as well as the importance of non-trade concerns of agriculture such as food security, aswas agreed in the WTO Ministerial in Doha.

The recent outcome of the Doha ministerial conference setsan agenda that all members fully benefit from the expansionof trade and that particular attention be paid to the needs andconcerns of developing countries and the world’s mostfragile economies, in particular concerning food security,which is a key issue for most developing countries.

Food security is a multidimensional issue which needs tobe addressed with coherent and long-term multi-sectoralstrategies, both from an international and domestic pointof view. Together with political dialogue and develop-ment cooperation, trade is a key component of EU exter-nal action to contribute to poverty reduction.

Some developing countries have been disappointed bythe lack of realisation of opportunities created by the

Figure 13: Pattern of protection facing LDC exports (pre-EBA)

Source: Unctad

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Canada EU Japan United States

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DC

exp

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Uruguay Round or by the extent of such opportunities.A number of developing countries perceived these as‘broken promises’ (Oxfam, 2001) of developed part-ners. Their complaints sometimes refer to inadequateefforts made in areas like increased market access fordeveloping country exports, such as dismantling of ag-ricultural protection or improved access for textiles andclothing, but more often addresses the balance of the

agreements as such and specifically a perceived bias inthe Uruguay Round outcome towards developed coun-try interests.

This disappointment with previous WTO agreements ledto an ambitious work programme in the WTO relating toexisting agreements, materialising in a ministerial deci-sion at the fourth WTO ministerial conference in Doha

Box 2: The Doha Development Agenda

1. Multilateral trade liberalisation provides the framework and the engine of world growth through a moreefficient global division of production. At the November 2001 WTO ministerial meeting in Doha the world’strade ministers — the majority of which represent developing countries — agreed to launch a new round ofmultilateral negotiations on trade liberalisation and related rulemaking in the WTO — the Doha DevelopmentAgenda (DDA), which is more ambitious than any previous efforts.

2. At Doha, WTO members committed to focusing on the interests and concerns of developing countries,thus ensuring that trade negotiations contribute to development. The new talks are expected to lead to the fur-ther opening of global markets and the facilitation of trade, especially in those areas where the developingworld is most competitive.

3. The launch of the new round of trade negotiations now can boost growth at a critical juncture for the worldeconomy. But the Doha Development Agenda also represents a fundamentally different approach to tradepolicy, launching broad negotiations under an overarching sustainable development objective, supported bytrade-related capacity building to help countries participate effectively. In this respect, the inclusion of envi-ronment on the international trade agenda is also groundbreaking; it should provide an instrument for improvedglobal governance in this crucial area.

4. The DDA epitomises the integrated approach to harnessing globalisation promoted by the EU, and cre-ates the basis for further changes in the global system. The inclusion of talks on a range of trade-related issuessuch as competition, investment, trade facilitation and government procurement after the next WTO ministe-rial conference in 2003 should ensure that market liberalisation takes place in a broader regulatory framework,helping countries manage and maximise the benefits of reforms.

5. The agreement reached in Doha to negotiate a multilateral framework for transparent, stable and predictableconditions for investment, is an important factor in this context. Participation to such a framework agreementis expected to provide greater certainty and to reduce the perceived risk for potential investors, thus helping toincrease the inflow of foreign direct investment — which is an increasingly important source of developmentfinancing; it helps to promote a healthy balance of trade, it encourages efficient production and stimulates tech-nology transfer.

6. The negotiation of a framework on competition, as agreed in Doha, is expected to complement the invest-ment agreement by helping countries to address anti-competitive practices by foreign or domestic firms andbuild efficient market structures, for the benefit of consumers and their economy more broadly. Directly relat-ed and important for the economic efficiency of countries is also the agreement to negotiate, after the fifthWTO ministerial conference, a multilateral agreement on transparency in government procurement.

7. Inefficient use of resources and infrastructure, time-consuming customs procedures and red tape continueto be a major constraint on developing country export performance. An agreement on trade facilitation in theWTO would aim to streamline procedures, cutting costs and red tape. The agreement reached in Doha to ne-gotiate trade facilitation therefore constitutes an important contribution to development.

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in November 2001, which comprehensively addressesissues relating to implementation (1).

Beyond the multilateral level, regional liberalisation canbe an important stimulus to further integration in the glo-bal economy. The number of regional trade agreements(RTAs) has been multiplying in recent years. RTAsshould reinforce cooperation on regulatory policies, in-cluding on the environmental and social dimensions ofsustainable development, particularly in a north–southcontext. In addition, they effectively lock in necessarydomestic policy reforms (in the political and economicarea), enhancing their credibility and transparency. Inboth these respects, a very successful example are theEurope agreements between the EU and the countries ofcentral and eastern Europe (CEECs), which have under-pinned CEECs economic transition over the last decade.

A key element in regional integration initiatives is the is-sue of regulatory approximation which increasinglyemerges as a necessary prerequisite for attaining sustain-able development objectives. Tariff dismantling at theborder is one necessary step in the process of trade liber-alisation. For goods and services to move freely amongthe parties, addressing trade-impeding regulatory barri-ers effectively is also essential. Therefore, deeper inte-gration or greater convergence/approximation of rulesand regulations can help to fully achieve the potentialgains from RTA participation.

In particular, progress towards the objective of liberalis-ing trade in services and investment, should be accompa-nied by a common regulatory framework in areas such ascompetition policy, public procurement, rules of origin,intellectual and industrial property and norms and stand-ards. This may increase the scope for benefiting fromtrade liberalisation inter alia contributing to the creationof an environment capable of attracting investment op-portunities, but attention must be given to potential ad-ministrative costs of implementation for developingcountries and the need to avoid the creation of overlap-ping sets of rules.

The costs of adjustment to trade liberalisation are a sig-nificant challenge to developing countries. The inclusionin RTAs of efforts to agree to common disciplines forregulatory regimes exacerbates such a problem. Flank-

ing policies are therefore paramount to help offset thesignificant loss of government tariff revenue and in-creased opportunity cost of administering RTA rules.

It is often argued that for most developing countries andespecially for the poorest ones, a north–south RTA with alarge industrial country is likely to be superior to a south–south RTA among developing countries, provided theright design encourages the necessary domestic reforms.

However, north–south and south–south integration canbe complementary. The EU in most of its RTA initia-tives promotes regional integration along south–south–north lines, where the advantages of trade liberalisationbetween a developed north and a developing south(locking in reforms, credibility, good governance, con-vergence, access to large markets, FDI incentives, tech-nology transfers, etc.) are combined with the benefits ofregional integration among the developing countriesthemselves (economies of scale, increased bargainingpower, larger markets attracting more FDI, etc).

Trade-related capacity building

In addition to trade preferences, a comprehensive ap-proach is required to enhance trade capacity if develop-ing countries are to take advantage of the opportunitiesthat trade liberalisation offers. Measures would includeincreased levels of comprehensive trade-related techni-cal assistance and capacity building to help countriesparticipate effectively in the multilateral trading system.In the short term, such assistance should focus on theability of countries to participate effectively in the WTOtrade negotiations, both as regards substance, by identi-fication of interests and objectives, and the more proc-ess-related aspect of developing their negotiationcapacity and skills. In the WTO, the Doha DevelopmentAgenda Global Trust Fund has been created to ensurefunding of the WTO technical assistance programmethat is being implemented to assist developing countriesin relation to new negotiations. Other international or-ganisations, such as Unctad and the World Bank as wellas specialised agencies such as the World Customs Or-ganisation and the World Intellectual Property Organisa-tion, are also important contributors of trade-relatedtechnical assistance and capacity building to help coun-tries participate in the multilateral trading system.

Coordination of this support is important to ensurecomplementarity and avoid overlap. Multilateral pro-grammes, such as the ‘Integrated framework for trade-

¥1∂ Doha also clarified the key issue of access to medicines in developingcountries, with the recognition that TRIPS does not prevent members fromtaking measures to protect public health.

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related technical assistance to the least developed coun-tries’ and the ‘Joint integrated technical assistance pro-gramme’, which involve several donor agencies, areexamples of coordinated multilateral programmes, tar-geting the poorest countries (least developed countriesand sub-Saharan African countries respectively).

In the medium to long term, assistance should be direct-ed at building countries’ capacity to implement the nego-tiation outcome, including assistance for regulatory andadministrative capacity, and to make use of the marketaccess opportunities by building trade capacity. In thiscontext, private-sector development is also important.

Viable and effective trade-related technical assistance andcapacity building in the longer term requires mainstream-ing of trade into development programming and into theoverall development strategies of developing countries asdefined in country strategy papers or poverty-reductionstrategy papers. As regards the EU, trade and integrationinto the world economy have been identified as one of sixpriority objectives for development policy.

Accompanying policies

Appropriate accompanying policy frameworks and goodgovernance are essential elements of a strategy to ensurethat all countries benefit from the opportunities for growthand development created by trade and investment liberal-isation. The introduction of economic reform and flankingpolicy measures will often require support from the inter-national community by cooperation to support economicreform and enhance the stability, transparency and credi-bility of the policy environment in developing countries,where domestic savings and investments are low (as e.g.the EC is already doing through partnership agreements,such as MEDA and the Cotonou Agreement with the ACPcountries).

Governance at a global level, by international coopera-tion and rule-making, can help support and lock in do-mestic reform, thus providing greater stability andpredictability. As regards trade policy, a rules-basedmultilateral trading system is likely to be the best guar-antee for a stable, international macroeconomic frame-work and predictability in trade and investmentconditions worldwide. In addition to the positive impacton export conditions, such an international frameworkcould help to support and sustain the necessary domesticpolicy reforms. The Doha WTO meeting agreed to nego-tiate international frameworks of rules on investment,

competition, government procurement and trade facilita-tion is significant in this context.

A framework of rules on investment, under which coun-tries would subscribe to fundamental principles such asnon-discrimination, transparency and predictability,would help to underpin national investment regimes,while leaving the formulation of such regimes to the gov-ernments themselves. Participation in such an agreementwould provide greater certainty and reduce the perceivedrisk for potential investors. It would also contribute tocreating an environment more conducive to domestic andforeign investment, which can bring technology, employ-ment and growth, build capacity and improve the tradeperformance of countries, and would be particularly im-portant for low-income developing countries.

As regards competition rules, negotiations in the WTOwill aim at agreeing on a basic framework agreement, in-cluding core principles of domestic competition regimes,modalities to benefit from international cooperation andsupport for capacity building in developing countries.This would not entail a harmonisation of domestic lawsand there would be flexibility as regards the introductionof domestic competition law or the maintenance of exclu-sions from the application of such law. A multilateralagreement on competition would complement an invest-ment agreement by helping countries to address anti-com-petitive practices by foreign or domestic firms and buildefficient market structures. The introduction of domesticcompetition policies would help countries to manage largeinvestors and ensure economic efficiencies, thus increas-ing the benefit to the local consumers and economy. Fur-ther negotiations have also been agreed to clarify andimprove anti-dumping rules with a view to limiting possi-ble abuse by both developed and developing countries.

The negotiation of an agreement on trade facilitation in theWTO will aim at streamlining customs procedures, cuttingcosts and red tape, which continue to be a major constrainton developing country export performance. A trade facili-tation agreement would imply significant savings, in par-ticular for developing countries, by helping governmentsto improve efficiency of controls and, ultimately, ensurehigher revenue intakes. The gains are expected to be par-ticularly important for small and medium-sized enterprisesin developing countries, for which the costs of compliancewith trade procedures are proportionately higher and a dis-incentive to international trading. Simplified trade proce-dures are also frequently cited by business groups asconstituting an important factor in FDI decisions.

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Negotiations on trade and environment, which werelaunched at the fourth WTO ministerial conference, areequally important for developing countries. Not only dothey aim at addressing particular market access concernsof developing countries; the increased certainty thatwould follow from a clarification of the interface betweentrade rules and multilateral environment agreementswould ensure predictability in market access conditions,thus limiting the risk of abuse of environmental consider-ations for protectionist purposes. It would also provide de-veloping countries with opportunities regarding increasedexports of environmental products.

A.4. Attracting foreign direct investment

In recent years, FDI (1) has received increasing interestfrom policy-makers, due to its growing economic im-portance for both developed and developing countries.Sales by foreign affiliates are now more than twiceworld total exports of goods, implying that firms use

FDI more than they use exports to service foreignmarkets (2).

The ongoing preparations of the ‘Financing for develop-ment’ conference also stress the important role that FDIcan have for economic development and hence povertyreduction (3), through technological transfer, productivi-ty increases or enhancement of export capacity. At thesame time, anti-globalisation protesters point to the neg-ative side-effects that multinational companies can haveon the host economy: rent extraction, crowding out ofdomestic investment, repatriation of profits, as well asthe irresponsible exploitation of natural resources.

A.4.1. Trends and figures

One of the most positive trends in developing countrieshas been the increasing importance that private-capitalflows have assumed over the past decade. Private-capitalflows totalled 87 % of all net long-term capital flows todeveloping countries in 2000 (Table 2, Section A.1.1);between 1990 and 2000, they averaged 75 %. Amongthese, FDI is by far the largest and most stable source ofcapital, at around USD 180 billion in 2000 (70 % of totalprivate flows).¥1∂ Foreign direct investment (FDI) is defined as an investment involving a

long-term relationship and reflecting a lasting interest and control (usuallyabove 10 %) of a resident entity in one economy in an enterprise residentin another economy (OECD, 1993). This definition captures both ‘green-field’ investment (i.e. when a new plant is built in the host country) and‘brown-field’ investment (i.e. the partial or total acquisition of existinglocal firms).

¥2∂ Unctad (2001).¥3∂ See the revised draft outcome, UN (2001a).

Figure 14: Distribution of world inward FDI stock (%)

Source: World investment report (Unctad), various issues.

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However, on a global scale, developing countries onlyattract marginal amounts of FDI: in 2000, 21 % of totalFDI inflows were in developing countries (1). On theother hand, the importance of developing countries ashosts has been slightly growing in the past two decades,with their share in inward FDI (2) stock going from 26 %in 1980 to 31 in 2000 (Figure 14). FDI inflows in per-centage of gross fixed capital formation, a good measureof the importance of FDI in the economy, have alsosteadily grown for the developing countries: from an av-erage of 5 % between 1989 and 1994 to 11 % between1995 and 1999.

In the geographical distribution of FDI, major differenc-es exist among developing regions (Unctad, 2001). Afri-ca has actually seen its share of inward FDI stock withindeveloping countries being reduced from 10 % in 1980to 5 % in 2000, while a less dramatic reduction has beenobserved for Latin America and the Caribbean countries(from 36 to 31 % over the same period). Foreign inves-tors in the past 20 years have favoured Asia, which haswitnessed an increase from 53 % in 1980 to 64 % in2000; the most spectacular increase has been seen inChina, which saw its share growing from zero to nearly20 % over these two decades.

FDI is also very concentrated within each region, with thethree top recipients accounting for more than half of FDIinflows. In 2000, Angola, Egypt and Nigeria represented50 % of total FDI inflows into Africa; Brazil, Argentinaand Mexico 66 % into Latin America and the Caribbean;while Hong Kong (China), China and South Korea ac-counted for 80 % of FDI inflows into Asia. Even thoughthis high concentration is often proportionate to the size ofthe country (which mostly reflects the amount of potentialsales), it also illustrates the fact that many countries havenot yet been able to attract the full potential flow of invest-ment, notwithstanding their liberalisation efforts.

The main source countries of FDI into developing countriesare also differentiated by region. For Africa, main sourceshave traditionally been France, the UK, the United States,and to a lesser extent Germany and Japan. Canada, Italy andthe Netherlands have recently gained in importance. In Lat-in America and the Caribbean, after the United States andJapan, Spain is the largest single investor in the region. In

Asia, the United States, Japan and European countries areall investing, while Asian countries themselves are invest-ing in the region (e.g. South Korea).

A.4.2. Impact of FDI on developing countries

The economic literature tends to agree on the overallpositive effect of FDI on economic growth in the hosteconomy (3). A distinction can be made between the im-pact of FDI at a microeconomic level and at a macroeco-nomic level. At microeconomic level, the channel of thiseffect mostly goes via technological transfer, wherebycontagion and knowledge diffusion improves productiv-ity and efficiency in local firms in various ways, andhence growth. One of the channels is through backwardand forward linkages between multinational enterprises(MNEs) and local firms. The former refers to linkagesbetween MNE and local suppliers, who benefit from bet-ter organisational structures and management skillslearnt from contacts with foreign firms. Local suppliersmay also have to meet higher standards of quality or de-livery speed, if they want to deal with foreign firms. Theoverall result is that technological transfer graduallymakes local labour more skilled, and hence localsuppliers become more competent at producing therequired intermediate goods for the MNEs. Similarly,forward linkages concern all spillovers towards distribu-tors, again in terms of organisational or managerial skillstransfer.

Active technological transfer arises when training of lo-cal employees by ‘imported’ managers, either in techni-cal skills or in more intangible ones (such as marketing,customer service, etc.), leads local workers to end up cre-ating their own firm. Passive technological transfer aris-es when local firms see their profits threatened by moreefficient MNEs and therefore have to increase productiv-ity by introducing new technologies or even just by be-ing more efficient in their production process.

The empirical evidence on positive FDI spillovers ismostly consistent for developed countries, while it ismore mixed for developing countries (Blomstrom,Globerman and Kokko, 2000). Evidence on Latin Amer-ican middle-income countries shows positive spilloversfor Mexico (Kokko, 1994) and Uruguay (Blomstrom etal., 1994), while Aitken and Harrison (1991) find noevidence for Venezuela.

¥1∂ Unctad (2001).¥2∂ Inward FDI stocks are estimated as the cumulation of inward FDI flows

(Unctad, 2000). ¥3∂ See Blomstrom and Kokko (1997) for a review.

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From a theoretical point of view, the beneficial effect ofFDI should be particularly strong in developing countries,as foreign technology may be the only source of innova-tion, given the few resources available at both private andgovernment level to invest in R & D. However, develop-ing countries may not have the minimum level of knowl-edge that is necessary to ‘absorb’ the foreign technology(Borensztein et al., 1998). This technology gap betweenforeign and local firms may prove particularly large in thecase of ‘resource-based FDI’ such as for oil or gas extrac-tion, where the gap between the MNE and its environmentis so wide that the dynamic benefits of technologicaltransfer do not arise (Lim, 2001). The recurrence of thetheme of ‘absorptive capacity’ therefore emphasises therole to be played in developing countries by human capitaland investment in education.

The effects of MNEs on the market structure of the hostcountry are not entirely clear. Through technologicaltransfer, MNEs may force local firms to become more ef-ficient and increase the general level of competition.However, they may also force out inefficient firms and be-come monopolists, given their better use of economies ofscale and firm-specific assets, in which case FDI couldlead to lower welfare in the host country. Moreover,MNEs may intentionally choose sectors where competi-tion is low, or where entry barriers, such as high sunkcosts, exist, to impose a monopolistic structure. Competi-tion policies and their effective enforcement are importantinstruments to address this aspect. The nature of FDI isalso relevant: a green-field investment, e.g. the establish-ment of a new plant, may indeed reduce the concentrationof the market, while a simple acquisition leaves it un-changed or increases it. Unfortunately, the empirical evi-dence on this subject has been inconclusive and the impactof FDI on market structure remains an open question (1).

In developing countries market structures tend to be im-perfect, with a low degree of competition. If this is cou-pled with a restrictive inward investment regime(e.g. with mandatory joint partnerships or domestic con-tent requirements) it may lead to attracting less efficientMNEs or those that use older technology (Moran, 1998),which therefore do not generate strong positive spill-overs. Moran also points out that a liberal trade and in-vestment climate is also conducive of export-orientedMNEs, which due to their exposure to international com-petition often bring new technology.

At a macroeconomic level, three main issues arise withinthe impact of FDI on developing countries: domestic in-vestment, employment and trade. Most government pol-icies are especially designed in order to attract FDI flowsthat would benefit these three aspects, as illustrated bySun (1998) for the Chinese case. Domestic investmentfuels growth; if FDI is conducive to greater investment,it will indirectly induce development. In this respect,joint-ventures allow local firms to gain the much neededfinancial and physical resources for new projects. This isoften the only way for developing countries to get finan-cial resources, especially when markets are too restric-tive to be attractive for foreign portfolio investors.

Again, the form of FDI matters for its impact on domes-tic investment (2). Acquisitions are merely a change ofownership, while green-field FDI has an immediate im-pact on domestic investment. The other side of the coinmay be a ‘crowding-out’ effect on domestic investmentby FDI, especially when local resources (capital or la-bour) are scarce. As mentioned above, better organisedand financially sounder MNEs may out-compete localfirms and they may therefore capture the best investmentopportunities in developing countries. The empiricalevidence generally shows that MNEs have a positive im-pact on domestic investment (3).

As far as employment is concerned, the effects are on thenumber of employed people or on their wages. In develop-ing countries, it is most likely that MNEs will employ la-bour-intensive processes, precisely in order to takeadvantage of low labour costs, hence increasing employ-ment opportunities. In terms of wages, since MNEs ‘export’their knowledge-capital to combine it with cheaper labour,often wages offered by foreigners are higher than elsewherein the local economy. As a result, MNEs may increase thewage gap between ‘skilled’ (relative to the average localworkers) and ‘unskilled’ workers in the developing coun-try, hence posing problems of rising inequality (4).

Trade and investment are complementary aspects ofcountries’ integration in the global economy. Empiricalstudies usually show that FDI can enhance the exportcapacity of the host country and this is especially truewhen foreign investors use the host country as a plat-form for exporting, rather than for selling in the local

¥1∂ Caves (1996).

¥2∂ Nunnenkamp (2001).¥3∂ See again Sun (1998) and Borensztein et al. (1998).¥4∂ See Feenstra and Hanson (1997) for the case of Mexico.

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market (1). In this sense, trade and investment can beseen as complementary and countries with open, pre-dictable trade policies can more fully contribute toFDI’s growth potential (2).

The fear that some may have that FDI could lead to a de-terioration in the trade balance of the developing countryseems to be unjustified. Vertically integrated MNEswould usually use imported intermediate goods, whichimpacts negatively on the trade balance; however, this isoffset by the fact that they will also export back their fi-nal product and that the value of final goods will exceedthat of the intermediate goods. In terms of spillovers, ex-port-oriented MNEs may also benefit local firms throughbackward linkages, i.e. by purchasing domestically pro-duced intermediate products and by improving their‘market-access’ capability at international level, andeventually lead to an increase in direct exports from localfirms, with a positive effect on the trade balance.

Overall, the impact of FDI on growth in developingcountries depends on various elements directly linked topolicy choices: a minimum level of human capital, acompetitive economy with liberal investment climateand a liberalised trade regime.

A.4.3. The challenge of attracting FDI

Given the perceived benefits of FDI on the host econo-my, developing countries elaborate initiatives to attractforeign investors (such as tax holidays or other fiscal in-centives) while at the same time designing schemes toencourage as many positive spillovers as possible(e.g. by imposing joint-ventures, local content require-ments or the use of specific technologies).

When looking at the determinants of FDI, it is clear thatmany are exogenous to government policies, such as ge-ographical position, country size and availability of nat-ural resources. The most robust empirical findingconcerns country size, with which FDI is positivelycorrelated (3). Beyond these, necessary conditions in-clude economic, political and regulatory fundamentals(such as good governance, rule of law and intellectualproperty rights protection) that ensure a stable environ-ment for foreign investors. These are first and foremostthe responsibility of local governments. Several empiri-

cal studies show in fact that corruption, complex andnon-transparent regulatory frameworks, as well as weakproperty rights all hamper FDI (4).

The liberalisation efforts in developing countries haveaccelerated since the 1990s with, for example, the elim-ination of licensing requirements, opening of previouslyclosed sectors, unlimited foreign ownership, or makingtax systems more neutral (5). Moreover, trade and for-eign exchange transactions were further liberalised andthe functioning of financial markets was improved. A se-ries of survey studies between 1987 and 1999 on 28 de-veloping countries show that all these countriesimproved their investment climate, with beneficial ef-fects on attracting FDI (6). Efforts of developing coun-tries in this direction can only be welcome, while itshould be clear that most responsibility lies at home,rather than with the international community.

The desirability of active government investment-promo-tion policies, in addition to these necessary conditions, isnot entirely clear. Evidence shows that such policies dohave a strong positive impact on attracting foreigninvestors (7). However, the cost of ‘marketing’ the poten-tial host country abroad can be a real issue for some devel-oping countries with scarce resources. Moreover, sector-specific promotion programmes in particular can createmajor distortions in the allocation of investment resourceswithin a country (8). The main role and challenge for inter-national institutions should therefore be to create mecha-nisms that facilitate FDI more globally.

Some mechanisms are already in place, such as the Multi-lateral Investment Guarantee Agency (MIGA), created in1988 (World Bank Group) to promote FDI into emergingmarket economies. MIGA offers political risk insurance(guarantees) to investors and lenders, and helps develop-ing countries attract and retain private investment. More-over, MIGA’s guarantee coverage requires investors toadhere to high social and environmental standards.

Making sure that all developing countries with a properinvestment climate fulfil their potential in attracting for-eign investors is crucial. Advisory services, such as theForeign Investment Advisory Service, created in 1985

¥1∂ Athukorala and Menon (1995) for the case of Malaysia, and Jansen (1995)for the case of Thailand.

¥2∂ Balasubramayam et al. (1999).¥3∂ Brainard (1997), Shatz and Venables (2000).

¥4∂ Hoekman and Saggi (1999), Wei (2000), Drabek and Payne (2000).¥5∂ World Bank (2001a).¥6∂ European Round Table of Industrialists (2000).¥7∂ Wells and Wint (1990).¥8∂ Moran (1998).

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within the World Bank, can help countries to reach theirpotential for attracting FDI, especially when disadvan-tages due to reputation effects are present (as in the caseof Africa). Studies on herd behaviour within FDI have infact shown that for investors entering a new market itmay be an important signal to see that other investors arealready established in the host country (1). This may inturn induce more and more investors to explore businesspossibilities in that country. Similarly, some developingcountries may be ‘stuck’ in a no-FDI position, only be-cause there never was an investor in the first place.

From another perspective, investment agreements mayalso be helpful in ensuring that appropriate protection toforeign investors is guaranteed. At bilateral level, the net-work of bilateral investment treaties (BITs) has considera-bly expanded since the 1980s: in 1998, 39 % of BITs weresigned between developing countries, while 36 % weresigned between developing and developed countries (2).Regional agreements involving investment frameworkshave also proliferated throughout the developing world(within ASEAN, CAEMC, WAEMU and Mercosur).

As far as EU initiatives are concerned, most bilateralagreements create the conditions for encouraging inwarddirect investment with partner countries, through the es-tablishment of regulations on investment and the repatri-ation of profits, as well as provisions for investmentpromotion and protection (examples include stabilisa-tion and association agreements in the Balkans, agree-ments with ex-CIS countries and Euro-Mediterraneanagreements). Within the Cotonou Agreement signed on

23 June 2000 with ACP (Africa, Caribbean and Pacific)countries, an investment facility has been put in place,which allows amongst other things to provide guaranteesin support of foreign investment.

While bilateral investment treaties may be a useful toolin ensuring and sustaining stability in investment rela-tions with important recipient countries, the sheernumber and complexity of such treaties are problematic,not least for developing countries with limited regulatoryand administrative capacity. A multilateral framework ofrules would be more cost-effective, and in addition pro-vide a higher level of transparency and stability, whileensuring non-discrimination. These benefits are particu-larly important for developing country governments.

The failure in 1998 of the MAI (multilateral agreementon investment) launched within the OECD in 1995(giving non-OECD members only observer status), in-deed showed that the proper forum for such an agree-ment should be a comprehensive multilateral one.Developing countries in fact resisted the loss of discre-tion in policy instruments, even though a ‘tie one’shands’ strategy may increase credibility in providing asound investment climate. At the Doha Conference ofNovember 2001, the 144 members of the WTO haveagreed on the case for a multilateral framework on FDI,that will be negotiated after the fifth ministerial meet-ing of 2003. Thus, during the next few years, the mainpolicy challenge concerning FDI, for developed anddeveloping countries alike, will be the negotiation,within the WTO, of the right framework on investment.This should help to ensure transparency, predictabilityand non-discrimination for FDI, and hence supporthigher levels of FDI worldwide.

¥1∂ Kinoshita and Mody (1997).¥2∂ Unctad (1999).

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B. Alternative financing instruments

Over the years, a number of other financing instrumentshave been proposed to complement official developmentassistance. As several of them, including the Tobin tax,take the form of international taxes, they are treated as agroup (Section 1). Two other proposals, an SDR (specialdrawing rights) allocation and the de-tax, are discussedin Section 2.

B.1. International taxes

The issue of an international tax to finance development isnot new. International taxes have, for example, been sug-gested as part of a solution for development both in theNorth–South report, by the group chaired by Willy Brandtin 1980, and in ‘Our common future’, the report of theWorld Commission on Environment and Developmentchaired by Gro Harlem Brundtland. The discussion on in-ternational taxes has mainly taken place within the discus-sion on financing of the United Nations and its activities (1).

In addition to financing development, international taxeshave been proposed as a way to finance the provision ofglobal public goods. Proponents argue that global publicgoods are best dealt with and financed at global level. Asefforts to provide a more safe, healthy and stable worldbenefit all, some international taxes could in this contextbe seen as a charge paid by those that benefit from theseefforts (2).

Several tax bases have been proposed. A tax on currencytransactions has so far received the greatest attention.Other proposals have discussed a tax on global activitiesor on the use of global public goods. Examples on pro-posed tax bases include, for example, air transport or air-freight, telecommunications and postal services,maritime shipping, trade, arms export, and carbon diox-

ide emissions. The issue of international taxes was raisedagain in the recent Zedillo report (3).

This section focuses on four proposals, which are mostoften referred to within international forums. The pur-pose is to assess the feasibility and to discuss the imple-mentation issues of these international tax proposals aswell as their efficiency and potential revenue. The taxesunder review are a tax on currency transactions, a tax oncarbon dioxide emission, a tax on aviation fuel and a taxon arms exports.

B.1.1. Taxes versus national contributions

The principle of a tax is that it is levied on certain activ-ities to finance public goods without being earmarked.This enables resources to be used in the most optimalway when circumstances change. While an internationaltax offers the same financing flexibility as ODA resourc-es financed out of national budgets, international taxes,once agreed, would become compulsory and would cir-cumvent the current difficulty of voluntary contributionsfrom governments.

However, developing international taxes would be a ma-jor challenge to international cooperation and coordina-tion, both to reach a political agreement in principle andto work out the legal and administrative infrastructureensuring a proper implementation of the tax. Moreover,an international tax could be seen as less fair from an eq-uity point of view than contributions based on GNP.

The EU experience shows how difficult it is to establishsupranational taxes. The EU has developed a secure andefficient system to finance its policies. It enjoys a fair de-gree of financial autonomy, although the lack of a trans-parent link between the taxpayer and the beneficiary ofthe revenue is seen as an element of the democratic def-icit of the EU institutions. The revenue side of the budget

¥1∂ In addition to the reports mentioned, see for example Cleveland, Hender-son, and Kaul (1995) and Najman and d’Orville (1995).

¥2∂ Najman and d’Orville (1995). ¥3∂ UN (2001b).

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is closely linked to common policies, with genuine ownresources (customs duties) and receipts from the applica-tion of a uniform rate to a harmonised VAT base. Re-forms in the 1980s have, however, shifted the emphasistowards a contribution system, mainly because of equityconsiderations (UK correction in 1984, introduction ofthe GNP contribution and the capping of VAT resourcein 1988). This move away from supranational taxes hastaken place despite the existence of an advanced eco-nomic and political integration with the correspondingwell-developed institutional and legal framework. As thecurrent framework of non-EU international cooperationhas not reached such a degree of integration, the feasibil-ity of reaching agreement on introducing internationaltaxes and making them operational can be questioned.

While the distinction is not always easy to make, it maybe important to distinguish between charges and taxes inthis context. A tax is, according to the OECD workingdefinition, a compulsory unrequited payment to the gov-ernment. This definition excludes charges and penalties,but includes for example social security contributionssince they are compulsory. A charge represents, on theother hand, a payment for a specific service. The individ-ual user is able to derive a particular benefit or servicefrom the charge, and the proceeds are earmarked to aspecific use (1). When discussions have taken place in in-ternational forums, for example on the aviation fuel tax,some have argued that it might be easier to organise thefinancing of specific international public goods throughcharges or other economic instruments instead of taxes.

B.1.2. The framework of international tax proposals

International tax proposals generally have a dual objec-tive. They aim to raise revenue as a means of funding de-velopment or the provision of global public goods, butthey are also seen as useful policy instruments to correctfor economic distortions and externalities by inducing achange of behaviour through changing the relative pricesbetween different activities. Some of the externalities areglobal by nature, thereby justifying a response at globallevel.

1. Currency transaction tax (CTT)

The tax that has raised the most attention is the tax onforeign exchange transactions. As discussed in Chapter

II, Nobel Prize winner James Tobin launched in 1972 theidea of a tax on foreign exchange transactions to discour-age short-term speculative capital flows. Tobin’s mainconcern was that the margin for manoeuvre of the mon-etary authorities in industrialised countries had been sig-nificantly reduced by the increased capital mobility. TheLatin American and Asian crises in the 1990s have reo-pened the debate on the link between financial crises andcapital mobility in unstable economic areas, with a spe-cial focus on ‘peripheral currencies’. This gave rise tonew proposals, in particular by Spahn (1996) andSchmidt (1999). Apart from its proclaimed potential tostabilise exchange-rate markets, proponents of the taxhave highlighted the potential proceeds of such a tax,and suggested turning it into an attractive source of addi-tional revenue for the fight against poverty.

2. Carbon tax

An international carbon tax has been discussed as a wayto internalise the negative environmental effects of car-bon dioxide emissions, through putting a price on emis-sions. The main advantage of a tax, compared toregulations, is that it induces emitters to choose an effi-cient, cost-minimising pattern of abatement. For this tobe the case, the tax should be applied at a uniform rateacross different users. As an international tax wouldequalise the marginal cost of emission reductions acrossthe world, the emission reductions would be allocated sothat the total costs for the world are minimised. Howev-er, the effects on different countries would be different interms of national costs, depending on weather condi-tions, the energy supply mix and the industrial structure.Another advantage of environmental taxes is that theyinduce technological change, as savings in terms of re-duced tax payments can be realised for all emitters.

Taxes on energy and carbon emissions have been ex-tensively discussed. A tax on oil as a source for financ-ing development was for example suggested in the‘Human development report’ of 1994 (2), which pro-posed a USD 1 per barrel tax on oil consumption andthe equivalent on coal. However, the issue of an inter-national carbon tax has mainly been discussed in rela-tion to the negotiations on the United NationsFramework Convention on Climate Change (UNFC-CC) as an instrument to reduce emissions. There was adiscussion on the concept of a tax in the beginning of

¥1∂ The International Bureau of Fiscal Documentation, the international taxglossary on http://www.ibfd.com. ¥2∂ United Nations Development Programme (1994).

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the 1990s. However, the agreement reached in Kyoto in1997 sets emission targets for the individual States andthe EU, while leaving it to the countries to decide howthis will be accomplished. At international level, theKyoto Protocol focuses on other economic instruments:emission trading, joint implementation and the cleandevelopment mechanism (1).

The issue of a global carbon tax was raised again in theZedillo report (2). According to this proposal, industrial-ised countries should transfer a share of their carbon taxreceipts that correspond to an agreed base rate to interna-tional level, while developing countries would be al-lowed to recycle all their tax receipts into their owneconomies. The report finds an international carbon taxmore promising as a source of funding international de-velopment than a tax on currency transactions.

3. Tax on aviation fuel

A tax on fuel used for international aviation is an indirecttax on emissions from aviation. Like the carbon tax, thetax would internalise external costs by putting a price onthe emissions of aviation. It would also result in a moreequal treatment in terms of internalising external costsacross different transport modes (3). This argument alsoholds with respect to the tax treatment of domestic andinternational aviation, as some countries already tax do-mestic flights.

A tax on international aviation fuel has also been dis-cussed as a source of funding of international develop-ment, but it has primarily been discussed as aninstrument to mitigate the emissions of green house gas-es, in particular carbon dioxide. The aviation industryhas grown considerably over the last 20 years, with anannual average growth in passenger-kilometres of 7.4 %since 1980. The Intergovernmental Panel of ClimateChange (IPCC) special report on aviation and the globalatmosphere projects a growth of 5 % per year between1990 and 2015, with fuel consumption and emissionsgrowing 3 % per year over the same period. Aeroplanesaccounted for about 2 % of total carbon dioxide emis-sions in 1992. This corresponds to 13 % of carbon diox-ide emissions from transportation (4).

The issue of a tax on international aviation has beenraised in several international forums, for example in theUN Commission on Sustainable Development. A tax onaviation fuel has been discussed within the EuropeanUnion on several occasions. The European Union fa-vours an international initiative on a tax on aviation fuelin the context of the International Civil Aviation Organ-isation (ICAO) (5). However, the current policy ofICAO, which remained unchanged by the 33rd ICAOAssembly in October 2001, is that it recommends the re-ciprocal exemption from all taxes on fuel taken on boardby aircraft in connection with international air services.As an environmental economic instrument, the ICAO fa-vours an open emission trading system and at the meet-ing in October, the assembly requested the developmentof guidelines for emission trading for internationalaviation (6).

4. Tax on arms trade

A tax on arms trade or production surfaced in the debateon international taxation in the UN framework on globaltaxes in the 1990s (7). Such a tax was considered as a le-gitimate contribution in the framework of initiatives ofprevention of conflicts and peacekeeping. Various possi-bilities have been mentioned in the debate: a tax on pro-duction versus a tax on trade and a tax encompassing allconventional arms or just limited to land mines. Howev-er, no concrete proposal has been put forward. TheFrench Minister for Finance has reactivated the proposalas an alternative to the currency transaction tax in thesummer of 2001, with a main focus on the exports ofarms (8).

B.1.3. Provisions and features of the tax proposals

1. Geographical scope and coverage

The risk of relocation of taxable activities constrains theability of national governments to tax them unilaterally. Inthe case of an immobile tax base, a unilateral tax wouldhave an immediate impact in terms of competitivenesslosses in relation to regions that do not apply the tax. Theresult would primarily be a loss of trade. If the tax base ismobile, this process is reinforced thought relocation of thetaxed activity. Thus, unilateral taxes run the risk of affect-ing international flows and market shares, with corre-

¥1∂ The Kyoto Protocol is available on http://www.unfccc.org.¥2∂ UN (2001b).¥3∂ European Commission (2001d).¥4∂ IPCC (1999).

¥5∂ European Commission (2001d). ¥6∂ ICAO (2001).¥7∂ See for example the proposal for the demilitarisation fund in the 1994

‘Human development report’, UNDP (1994).¥8∂ Malingre (2001).

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sponding effects on employment and wealth in affectedregions. Furthermore, tax competition models demon-strate that coordination of tax policy between a group ofcountries or within a region is beneficial only if the mobil-ity of the tax base is limited to the geographical border ofthe countries that cooperate (1). Therefore, the introduc-tion of a new tax by a group of countries of a region is like-ly to be more acceptable for less mobile tax bases. The taxwould, in this case, have limited effects on relocation andcompetitiveness. The risk of relocation of economic activ-ities is very high in the case of the tax on currency trans-actions, due to the high mobility of the tax base. The newtechnologies of electronic settlement systems make it eas-ier to relocate financial centres to non-taxing jurisdictions.This is shown by the creation of the Eurodollar market inLondon after the introduction of the ‘interest equalisationtax’, a US Tobin-like tax. Given the nature of the two-sid-ed tax, only if both sides of a transaction are conducted ina tax haven, would the tax be avoided in full. One partnerwill not have an incentive to shift his business to the havenunless the other does so at the same time. This lock-in ef-fect can prove to be discouraging, but if not, the volume ofthe relocated activity will be extremely difficult torecuperate (2). A unilateral application of the currency taxbase could constitute a disincentive to the use of the taxedcurrency for the citizens, institutions and companies oper-ating outside the currency zone. A unilateral geographicaltax at, for example, EU-level with respect to non-EU cur-rencies clearly has a risk of relocation and substitutionthrough other currencies (3).

From this perspective, implementing a sustainable CTTwould require a multilateral approach, including the will-ingness to apply the tax in the major financial centres.

While Tobin initially launched his proposal with theUnited States in mind, shortly after the breakdown ofBretton Woods (4), the Spahn variant is specificallyaimed at the peripheral currencies vis-à-vis the dollar,which accounts for about 20 % of total currencytransactions (5). In Spahn’s view, there will be three keycurrency zones in the future: the dollar, euro and yenzone. Other currencies will be linked unilaterally to oneof the key currencies, by stabilising the exchange rate or

by applying the Spahn tax (6). In contrast, Schmidt’s pro-posal covers all currencies (7).

There may be greater scope for cooperation on a regionallevel for the three other taxes under review (the carbontax, the international aviation fuel tax and the tax onarms exports) as they have less mobile tax bases. How-ever, partial relocation or tax-planning activities mighttake place.

An extensive geographical coverage may also be essen-tial to secure the effectiveness of a tax on aviation fuel.A tax on international aviation fuel with a limited geo-graphic scope could result in an increase of emissions.An airline’s desire to reduce fuel costs could causeplanes to be re-routed, particularly on long-haul flights.Taxes could also be avoided by tankering, which is whenan aircraft takes on more fuel than is needed for a flightto avoid purchasing more expensive fuel at the next stop.However, this also requires using additional fuel to carrythe extra fuel load. In a study for the European Commis-sion on an EU tax on all departing flights within EU, itwas estimated that tankering could reduce the tax reve-nue by 25 % and the emission reduction by up to70 % (8).

Implementing a tax on arms exports is facilitated by thehigh concentration of this industry in a limited number ofcountries, mainly the United States, France, the UK andRussia, although concentration is difficult to measure ex-actly as arms export volumes are not regularly publishednor stable over time. The French proposal estimates thatthe United States, France and the UK accounted for 70 %of the world arms exports between 1993 and 2000. Majorexporting countries have made strong political commit-ments to support the control of arms exports and to reacha greater transparency in the arms trade. Major initiativesin this direction are, in particular the UN Resolution to es-tablish the UN Register for conventional arms in 1991, theWassenaar Arrangement approved in 1996 and the Euro-pean code of conduct on control of arms exports adoptedin June 1998.

The major exporters could play a leading role in a tax in-itiative, although it has never been mentioned in any ofthese frameworks. The risk of relocating arms produc-

¥1∂ Sørensen (2001).¥2∂ Conseil Supérieur des Finances de Belgique (2001). ¥3∂ Assemblée Nationale de France (2000).¥4∂ Tobin (1978).¥5∂ See Section II.C.1.3.

¥6∂ Belgian Senate (1999–2000)¥7∂ The Schmidt proposal is described in Cassimon (2001).¥8∂ The result is dependent on the evaluated tax level. In this case, ECU 245/

1 000 litres. See Resource Analysis et al. (1999).

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tion might not be a major threat due to the high technol-ogy content of some segments of the arms industry andthe importance of State contracts in the turnover of armindustries. However, during the 1990s, the militaryindustry has been increasingly privatised and armsproduction has been internationalised through cross-bor-der joint ventures or mergers of arms-producingcompanies (1). Therefore, a tax applied unilaterally bythe major exporters might reduce the competitiveness ofthe domestic industry and could therefore require a wid-er coverage other than the major exporters.

2. Tax base

The base for the tax needs to be clearly and unambigu-ously defined in order to facilitate equal collection andenforcement across nations. In order to capture the eco-nomic benefits of the taxes as presented above, the taxbase generally needs to be as broad as possible. Defininga common tax base is seen as technically difficult for thetax on currency transactions and not straightforward forthe exports of arms, while technical solutions might existfor carbon or aviation fuel taxes.

In the case of a tax on currency transactions, it is dif-ficult to define the tax base. Introducing exemptions forobvious non-speculative transactions (such as traveller’scurrency exchanges and other clearly-defined non-spec-ulative banking operations) and thresholds (to reduce thecost of smaller cross-border transactions) could open thedoor to tax avoidance. In the case of thresholds, it is ofparticular importance to take into account the costs ofsplitting transactions, both at the retail and at the whole-sale market. It has been debated whether all spot markettransactions, financial derivatives or financial markets asa whole, excluding the issuing of bonds and shares,should come under the scope of the tax.

Whether the tax should apply within a given country orto specific transactions regardless of where they takeplace remains an open debate. The field of application ofa CTT can be defined geographically, can be based onthe currency involved, or on a combination of both. Ageographical definition implies that all foreign exchangeoperations executed on a territory be subject to the tax,independent of the currency. In contrast, if the base is thecurrency involved, it is the conversion itself that is taxedindependent of where the transaction took place. In this

view, all conversions in the taxed currency would betaxed even outside the relevant currency zone. Combin-ing both options raises the question of whether both con-ditions should be applied or whether only one wouldsuffice for taxation. If both conditions need to be ful-filled, only the conversions in the taxed currency execut-ed within its currency zone would be taxed. In the secondinterpretation, all conversions within the currency zoneare involved, independent of the currency, and all trans-actions in the taxed currency, independent of where thetransaction takes place (2).

Instead of taxing individual buying and selling opera-tions, Schmidt proposes to tax net positions at the levelof a centralised settlement system. This would circum-vent enforcement problems related to the identificationof intermediary transactions and financial derivatives.However, the Schmidt proposal still hinges on the cover-age of electronic settlement systems, which are less usedby developing countries. The settlement systems are de-veloped on a voluntary basis to reduce settlement risk.There are neither reporting obligations nor standardisedformats for supplying detailed information. Using thesesystems for a CTT would affect their structure and theirlegal status. Moreover, foreign exchange transactions donot necessarily involve banking operations and positionscan be netted out between companies (3). The CTTenforcement mechanism should also capture the non-banking part of the tax base in order to prevent the sub-stitution of bank trading through non-taxable foreign ex-change activities. Even for interbank operations, thesettlement systems include transactions that should notbe part of a CTT base.

To be effective, a carbon tax needs to cover all fossil fu-els according to their carbon content as well as all usesand users. One possibility is to levy the tax close to thesource of the extraction of the fuel (‘upstream tax’) in or-der for the price signal to create a broad set of market re-sponses as possible. This could be implemented at themouth of a mine for coal, at the refinery gate for oil or atthe pipe for gas. In contrast, the current European Com-munity legislation on excise duties follows the destina-tion principle; that is the tax is paid where the product isconsumed. In practice, the tax is charged when the prod-uct is released for consumption, which will differ ac-cording to the product. To facilitate the trade in excisable

¥1∂ Sköns (2000). ¥2∂ Conseil Supérieur des Finances Belgique (2001).¥3∂ Verfaille (1999).

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products within the EU, a system of suspension arrange-ments has been created under which taxable productscan be moved without levying the tax within the EU. De-pending on the stage at which the products are taxed,similar arrangements would have to be developed at glo-bal level.

A tax on international aviation fuel could either bebased on emissions, such as carbon dioxide, energy con-tent or fuel price. A flat rate per tonne would give a dif-ferent result than a percentage of the price, as fuel pricesdiffer widely among regions (1). As there are a limitednumber of actors and well-defined procedures for inter-national flights, it should be relatively easy to define thetaxable event.

A tax on arms exports could be technically defined as acustoms duty, although customs duties are more common-ly used on imports and the monitoring would be donethrough customs. One of the bottlenecks in the interna-tional fight against the proliferation of arms is the pre-cise common definition of arms. Within the EU, the tradeof conventional arms is regulated by Article 223 of theTreaty, and thus not a Community competence. The defi-nition of the tax base could rely on the international agree-ments for arms control. The UN Register for conventionalarms, the Wassenaar Arrangement and the European codeof conduct on control of arms exports have all defined listsof arms equipment. They have also adopted reporting ob-ligations and systems of exchange of information betweenparticipating countries in their efforts to improve transpar-ency. Several technical difficulties would need to be clar-ified, in particular whether the tax base would be limitedto conventional arms or would include non-conventionalarms, whether it would be limited to military weapons orwould include small arms. Only the Wassenaar Agree-ment covers goods with dual uses, mainly high-techequipment or biological goods, which have both civilianand military applications. But the main difficulty for usingthese frameworks for tax purposes is that none of theagreements are legally binding. In practice, the reportingof exports of arms remains voluntary and is incomplete,ambiguous and not uniform across countries (2).

3. Tax rate

In the case of a tax on currency transactions, there is noagreement on the exact tax rate to be applied. For the tax

to be effective, the rate should be sufficiently high toprovoke the desired effect. Current proposals vary from0.003 to 0.25 %. Spahn has introduced the notion of aprohibitive rate for the purpose of banning speculationon the foreign exchange markets. However, there is noagreement as to what rate is prohibitive. The answershave ranged from 10–50 to 30–100 %.

According to economic theory, environmental taxesshould be set at a rate such that the marginal damage costis equal to the marginal cost of emission reduction. Theimplementation of the tax would then lead to a situationwhere the marginal abatement cost is equalised acrossemitters. However, the damage cost is very difficult toestimate in practice (3). The damage cost estimates pre-sented here are based on stabilising the concentration ofgreenhouse gases in the atmosphere on a level equivalentto a doubling of pre-industrial levels. The IPCC secondassessment report (1996) presents an interval of estimat-ed values, which range from USD 5 to USD 125 (UnitedStates, 1990) per tonne of carbon emitted. A study for theEuropean Commission presents a narrower interval ofUSD 9.1 to USD 65.1, with a median value of USD 28per tonne of carbon emitted (United States, 1997) (4).These estimates represent a wide range and a great un-certainty in terms of determining an optimal tax level forcarbon dioxide emissions.

4. Revenue

The revenue of a tax will depend on the level of taxationand the related behavioural change, as well as on severalother factors, such as the geographical application of thetax.

Part of the interest for a tax on currency transactions inthe current debate is its potential revenue collection. TheFrench Treasury, the Finnish Ministry of Finance and theBelgian High Council for Finances present estimates ofthe tax proceeds and sensitivity of the results to variousparameters. They start from the 1998 daily volume ofcurrency transactions close to USD 1 500 billion as esti-mated by the BIS. Assuming a price elasticity of be-tween – 1.5 and 0.5, allowing for fraud or tax avoidanceof up to 25 %, the proceeds of a tax with a rate of 0.01 to0.1 % would be within the range of USD 20 andUSD 200 billion. Earlier estimates had been even higher,mentioning several hundred billion US dollars. The

¥1∂ Michaelis (1997). ¥2∂ Carlman (1998).

¥3∂ See for example Cuervo and Gandhi (1998) and OECD (1997b).¥4∂ Capros et al. (2000).

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more recent Spahn and Schmidt proposals, which applythe tax to a limited part of the base, would provide sig-nificantly lower revenues than these estimates. Howev-er, all these calculations are hypothetical and the absenceof experience with such a tax makes it difficult to pro-vide reliable estimates.

The same caveat holds for other international taxes. Themodels that simulate the effects of a carbon tax usuallyuse the tax as an instrument to equalise marginal costsacross users and nations. The focus is to evaluate the ef-fects on the total economy, not on the generated tax rev-enue. The revenue is also channelled back into theeconomy in the different ways, which affect the result.Thus, it is difficult to give estimates on the potential rev-enue. However, estimates quoted in the debate rangefrom USD 66 billion for the UNDP (1994) proposal ofUSD 1 per barrel of oil to USD 750 billion per year ac-cording to Cooper (1998), using OECD model results for2020. Cooper refers to global carbon emissions of 5.2billion tonnes, implying an implicit tax rate of USD 144per tonne of carbon. Recent estimates of the marginalcost of carbon to implement the Kyoto Protocol targetswould result in tax revenues in the lower range of this in-terval, if such targets would be implemented with a car-bon tax. All these estimates point to large uncertainty,like in the case of the tax on currency transactions. Asaviation fuel only constitutes a small part of the total useof fossil fuels, the revenue potential of a tax on aviationfuel is considerably lower.

No revenue figures have been mentioned in the discus-sion on the tax on exports of arms. As mentioned above,there is no precise estimate of the volume of arms trade.The volume is estimated to be in the range of EUR 30 toEUR 50 billion per year depending on the year and thesource. The third annual report of the EU code of con-duct on arms exports indicates that export licenses issuedby Member States amounted to roughly EUR 15 billionin 2000. Carlman (1998) quotes a figure of USD 10.8billion for the 1997 US exports. UN data are more out ofdate but are still broadly in line with these figures. What-ever rate is applied, this tax base would not, in any case,generate proceeds of the order of magnitude mentionedfor the tax on carbon dioxide or currency transactions.

5. Efficiency and equity

Efficiency relates to the extent to which the tax will con-tribute to its objective and at which cost. As a generalprinciple, it depends on the price elasticity of the tax base

and the possibilities of relocation or substitution, whichmight reduce the tax base if a tax is introduced. Very lit-tle is known or can be measured in the cases of taxeswhich have not been applied in practice, such as a tax oncurrency transactions or exports of arms. The assessmentof environmental taxes can draw on national or regionalexperiences, raising, however, the issue of computing aworldwide impact.

Equity is the second dimension to consider when assess-ing the impact of a tax. Horizontal equity refers to theprinciple that ‘equals should receive an equal treatment’,while vertical equity refers to the progressivity of the taxamong taxpayers. In the framework of an internationaldebate, equity would, however, focus on the impact ofthe tax on the distribution of income between countries.

Very few studies have investigated the issue of equity forthe currency transactions tax. In this context, most of thefocus has been on how to avoid that the tax penaliseshedging activities on the retail market, as includinghedging activities would result in a shift of the tax bur-den to households’ and corporate sectors’ normal tradeand investment activities. The overall impact of the taxon currency transactions on world income distributiondepends primarily on the currencies covered by the tax.

As fossil fuels generally have negative price elasticity,even if it is low, a carbon tax would reduce emissions.Simulations of the impact on the economy generally indi-cates a negative effect on GDP growth at national level,but the results depend heavily on how tax receipts are re-distributed. Analysis of the distributional effects of carbonand energy taxes show that the effects on the income dis-tribution of these taxes are generally regressive to neutralin relation to income in developed countries. Few studieshave been done for developing countries, but the results ofone study from Pakistan indicate that a carbon tax couldbe income neutral to progressive. The consequences interms of total costs of an international tax would be verydifferent for different economies (1). This reflects largedifferences among countries in both the structure of ener-gy use and in the available technology. Generally, devel-oping countries are more carbon-intensive in relation toGDP than developed countries (2). This translates intogreater percentage losses in relation to GDP for develop-ing countries of an international carbon tax. However, the

¥1∂ Cuervo and Gandhi (1998).¥2∂ Figures of energy intensivity in relation to GDP are available on the Inter-

net (http://www.eia.doe.gov/index.html).

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net effect on different countries will depend heavily onhow the revenue is allocated. In addition, there is the effi-ciency gain of the optimal allocation of emission reduc-tions across the world, in comparison to a situation withuncoordinated taxes on a national level (1).

An international tax on aviation fuel could contribute toreduced emissions from aviation. An increase in the costof fuel would be passed on to airline customers and wouldresult in a lower demand for air travel and freight. It wouldbe expected that airlines would also respond by reducingtheir fuel consumption through changes in their opera-tions, as well as through the use of more energy-efficientaircraft. Both these responses would result in lower emis-sions. Airline profits would though be negatively affected,particularly in the short term. An international tax on avi-ation fuel would also affect parts of the world differently.Nations or regions that are dependent on long-distancetransport for trade and tourism would be disproportionate-ly affected when compared to other countries. However,the overall effects are dependent on the level of the taxrate (2). It should also be noted that other economic instru-ments, for example emission trading or revenue neutralcharges, could be equally efficient environmentally.

A tax on arms exports would undoubtedly be seen as away of strengthening the commitment of arms-exportingcountries towards arms-control initiatives. Whetherarms purchases are price-elastic and whether a tax wouldeffectively reduce arms trade is open to debate. Theoverall effect of the tax on arms exports would need tobe gauged against other forms of government support inthe form of export guarantee credits, loans or grants toarms producing companies. Carlman (1998) mentionsthat ‘more than half of the US weapon sales are now fi-nanced by taxpayers instead of foreign arms purchasers’and indicates ‘similar tendencies in other major armssupplier countries.’ It might therefore be more effectiveto withdraw subsidies than to introduce a new tax to curbproliferation of arms at world level.

B.1.4. Legal basis and compatibility with existing legislation

An international cooperation on taxes could be undertak-en in different institutional frameworks. One possibilityis to establish a form of an internationally agreed code ofconduct, which is not legally binding. The implementa-

tion of the tax would then take place in countries by na-tional authorities. However, a code of conduct wouldstill give room for tax competition through differences inthe implementation and the interpretation of the code. Inorder to avoid the problems raised here, extensiveinternational coordination would need to be based on alegally binding international agreement. The agreementwould need to address all issues of the definition of thetax base, the level of the tax rate, the implementation andadministration of the tax, in order to minimise the risk oftax avoidance. It would need an extensive coverage ofcountries in order to facilitate the implementation of thetax. Otherwise, there would be a risk of relocation of fi-nancial centres, polluting industries or flight hubs.

An international tax could be collected by the individualcountries or by an international organisation. Both ap-proaches raise questions on administration, compliance,audit, collection and costs. The key issue is how to ensureuniversal application, compliance and enforcement. In thecase of collection at national level, it would require an un-precedented degree of coordination among countries,such as a worldwide exchange of information. Differencesin legislation, in administrative standards and in applica-tion could give rise to relocation to places where the stand-ards are known to be lax. An international body, such asan international tax organisation (Box 3) would potential-ly solve some of these difficulties, but it would imply thatthe national governments would have to recognise thecompetence of the international body in defining the taxprovisions, and collecting and controlling the revenue.

Existing international institutions could also manage aninternational tax. However, this would require a substan-tial extension of their mandate and competence. Tobinhas suggested that the revenue from a tax on currencytransactions could be allocated to the Bretton Woods in-stitutions, which also could be given a role in the admin-istration of a tax. The conference of the parties under theUnited Nations Framework Convention on ClimateChange is currently the forum for the international workand negotiations on climate change, and could play arole in implementing an international carbon tax. For aninternational tax on aviation fuel the ICAO could play arole in the implementation and administration of a tax:187 countries of the world’s 194 (February 2001) aremembers of ICAO.

An international tax raises issues of compatibility withother international agreements as well as with nationalpolicies. A tax on transactions between the euro and cur-

¥1∂ Cuervo and Gandhi (1998) and OECD (1997).¥2∂ Michaelis (1997).

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rencies of other EU Member States is likely to be foundcontrary to the Treaties. Furthermore, the compatibilityof a CTT applied by EU Member States vis-à-vis the restof the world with the Community’s obligations withinthe WTO remains to be explored.

A carbon tax could also raise problems of compatibility atinternational level. The international community has al-

ready agreed on other instruments to reduce carbon dioxideemissions in the Kyoto Protocol. At national level, an inter-national carbon tax could imply a loss of domestic revenuefor those countries, including some Member States, thathave already implemented a tax. For the Member States ofthe EU, there is also a question of compatibility with themineral oil directive (92/81EEC) as this directive exemptscertain uses of fuel from excise duties on mineral oils.

Box 3: Towards an international tax organisation?

The final report (1) of the High Level Panel on Financing for Development, chaired by Ernesto Zedillo, callson governments to ‘consider the benefits of’ an international tax organisation (ITO). To some extent, the callfor an ITO flows from other parts of this report, in particular the suggestion that the world should introduceglobal taxation for the solution of global problems. In other words, a system of global governance dealing withissues such as development assistance, humanitarian aid and other global public goods requires global as wellas sovereign taxes to finance them properly.

The panel’s case for an ITO rests on three main pillars. (1) The tax systems of most countries developed at atime when trade and capital movements were heavily restricted. In today’s increasingly global economy, theavoidance of double taxation therefore rests on conventions agreed by individual governments, but the reportcriticises these as ‘complex’ and ‘in some respects arbitrary’. (2) The taxes that countries can impose on trans-portable goods and on mobile factors is ‘constrained’ by the tax rates of others. Tax competition is leading to‘tax degradation’, and increased tax evasion with respect to income from capital located outside the taxpayer’scountry of residence. (3) Given the panel’s call for global taxation to finance global public goods, there wouldbe a role for an ITO in developing and implementing such taxes.

It is clear that the panel sees the main benefit of an ITO as a way of combating tax evasion and restraining harmfultax competition. These would, it claims, contribute to increased tax revenues from dishonest taxpayers and mo-bile factors of production. The report claims that most people would regard this as an ‘unambiguous gain’.

Activities (2) under the umbrella of the ITO could include: (i) identification of main tax trends and problems, andcompilation and/or generation of relevant statistics and tax information, leading to the publication of an annualtax developments report; (ii) provision of technical assistance to countries; (iii) development of internationalnorms in tax policy and administration; (iv) acting as an arbiter and provider of surveillance over individual coun-try, regional and global developments. The panel report adds a number of other possible functions of an ITO: (v)developing a system of unitary taxation of multinationals; (vi) promoting and enforcing a personal tax systemwhereby nationals are taxed on their worldwide income regardless of where they reside.

The panel acknowledges that other organisations are already addressing these issues or the effects of them —the OECD, Unctad and the IMF are mentioned. However, it argues that OECD membership is restricted —implying, although it does not say so specifically, that not enough countries have a voice in this organisation.The suggestion appears to be that an ITO would pull together the disparate work already being done, althoughagain this is not explicit. In short, the tasks concerned would be better tackled at a global level.

(1) United Nations (2001b).(2) The report largely bases its proposals on a paper by V. Tanzi. Tanzi, V., ‘Is there a need for a world tax organisation?’ in Razin, A. and E. Sadka (eds)

(1999).

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A tax on aviation fuel, including a carbon tax, wouldraise problems of compatibility with the Convention onInternational Civil Aviation (the Chicago Convention)from 1944. The convention provides that fuels on boardaircraft in transit should be exempt from customs duty,inspection fees or similar national duties or charges. Inaddition, numerous legally binding bilateral air serviceagreements, which exist between individual States usu-ally contain clauses to the effect that both fuel in transitand fuel supplied in the territory of the contracting partyshould be exempt from fuel taxes. This is consistent withthe ICAO policy, ‘which recommends inter alia the re-ciprocal exemption from all taxes levied on fuels takenon board by aircraft in connection with international airservices’ (1). Furthermore, ICAO also recommends thatenvironmental levies on air transport should be in theform of charges rather than taxes. Thus, the funds col-lected should be used within the aviation industry to mit-igate the environmental impact of emissions fromaviation. The 33rd session of the ICAO Assembly inSeptember/October 2001 did not bring any change inthis policy (2).

A tax on exports of arms is likely to generate fewer prob-lems of compatibility with international trade treaties. AtEU level, arms exports are not part of the Communitytrade regime although goods with dual uses are.

B.2. Other proposals

B.2.1. The de-tax

The de-tax is a more recent proposal to provide addition-al financing for development purposes. Building on anItalian idea that goes back to the early 1990s, it has beenlaunched as an alternative to proposals for compulsoryfinancing through taxation. Under this scheme, consum-ers would be invited to allocate a 1 % rebate, granted bythe vendor, on the value of their purchases to an interna-tional development project which the vendor has chosento support. The government would exempt this contribu-tion (it would ‘de-tax’ it) from VAT and company in-come tax. Apart from this tax subsidy, the role of thegovernment would be limited to monitoring the ethicalfunds and their activities.

The de-tax scheme does not require an internationalagreement either for the collection or for managing and

spending resources. It is completely voluntary as withineach country, citizens and businesses are free to decideto participate.

The scheme looks attractive because, as is the case withthe Tobin tax, potential revenue looks high. Even if onlya minor part of shops and enterprises agree to participatein the scheme, and assuming that a significant number ofcustomers endorse the project chosen by the vendor, therevenue could be substantial.

The voluntariness of the de-tax is, however, also its mainweakness. The system rests fundamentally on the as-sumption that enterprises are prepared to forgo, on a per-manent basis, 1 % of their turnover. In terms of profitmargins, this share will be much more substantial. Whilethe system does provide an incentive through the tax re-bate (which amounts to an involuntary contribution byall taxpayers), it is unclear why retail sellers and busi-nesses would be motivated to participate in this particu-lar scheme.

B.2.2. An SDR allocation

Since the creation of the special drawing right (SDR) bythe IMF, proposals have been made for using SDR allo-cations for purposes other than the original one, which iscoping with a long-term global need for internationalliquidity. The possible use of SDR allocations for theprovision of development finance was already men-tioned in the discussions leading to the creation of theSDR (3), and proposals of that kind have resurfacedregularly, most recently in the Zedillo report (4) and byGeorge Soros (5). While the Zedillo report does notelaborate on the post-allocation redistribution scheme,Soros explicitly proposes to redistribute the allocatedSDRs through trust funds to specific countries and/or tofinance the provision of global public goods.

The SDR was conceived in the 1960s as a response to theperceived inability of the international monetary and fi-nancial system to ensure adequate growth of internation-al liquidity. Under the Bretton Woods gold exchangestandard, international reserve creation was basicallyconstrained by gold production and by claims on the re-serve-currency country, a role assumed since World WarII by the United States (6). The growing concerns about

¥1∂ ICAO (1996).¥2∂ See also ICAO (2001) and ICAO (1994).

¥3∂ IMF (1987).¥4∂ United Nations (2001b).¥5∂ Soros (2001).¥6∂ This problem was first formulated by Triffin (1961).

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the limits of international reserves creation was stated intwo studies by the IMF and the G10 which led to the pro-posal for the creation of new reserve assets (1), and to thecreation of the SDR in 1969 through the first amendmentof the IMF articles of agreement.

The SDR is an artificial currency unit defined as a basketof the major currencies. The objective of the SDR was tosupplement IMF members’ existing reserve assets (offi-cial holdings of gold, foreign exchange, and reserve po-sitions in the IMF). They are created through a processof allocation. A decision to allocate SDRs is made by theBoard of Governors on the basis of a proposal by themanaging director with the concurrence of the executiveboard, and requires an 85 % majority of the total votingpower. Two allocations of SDRs have taken place, thefist one in 1970 and the second one in 1981. On both oc-casions, SDRs were allocated in proportion to the quotasof Fund members agreeing to this allocation.

The SDR should be seen as a means to obtain other re-serve currencies from other Fund members. The systemfunctions because Fund members holding less SDRsthan their cumulative allocations pay an interest rate onthis negative balance while the ones holding more SDRsthan those received in allocations receive an interest tocompensate for the yield lost on the exchanged reservecurrencies. The SDR interest rate is the average interestrate of short-term instruments in the main reserve assetcurrencies.

The conditions that could lead to an SDR allocation arecontained in the Fund’s articles of agreement. ArticleXVIII refers to the existence of a long-term global li-quidity need but refrains from specifying how this needis to be assessed: ‘In all its decisions with respect to al-location and cancellation of SDRs, the Fund shall seek tomeet the long-term global need, as and when it arises, tosupplement existing reserve assets in such a manner aswill promote the attainment of its purposes and willavoid stagnation and deflation as well as excess demandand inflation in the world.’ Experience has shown that itis not straightforward for an 85 % majority of the IMFboard to agree on the existence of long-term global need.This, together with the changes that took place in the in-ternational monetary system since the establishment ofthe SDR mechanism (suspension of gold convertibility,elimination of par values, evolution of international cap-

ital markets, and increased number of reserve curren-cies) explain why only two general allocations tookplace.

Decisions on an SDR allocation have, however, not sole-ly been taken in light of a perceived global liquidityneed. In 1997, the IMF Board of Governors acknowl-edged that the benefits of the SDR mechanism had notaccrued equally to all IMF members: the early Fundmembers had been allocated SDRs twice, the ones whojoined the IMF in the 1970s once and the rest (one fifthof the Fund membership which joined the IMF after thelast SDR allocation took place in 1981) never. The boardtherefore decided on a fourth amendment to the articlesto allow for a one-time specific SDR allocation thatwould increase the ratio of allocated SDRs to quota forall IMF members to a same threshold. This allocation,which would result in a doubling of the amount of exist-ing SDRs, has yet to enter into force. It will become op-erational when IMF members having 85 % of the totalvoting power will have accepted it, which will be thecase with the acceptance by the United States.

Proposals for SDR allocations such as the ones proposedby Soros and the Zedillo report attempt to bridge the‘discrimination’ between, on the one hand, countries thatissue reserve asset currencies, and thus have access to al-most spontaneous financing, and, on the other hand, de-veloping countries that hardly have access to capitalmarkets. The argument is that an SDR allocation pro-vides all IMF members with additional ‘owned’ re-serves. These additional reserves could result inincreased financial markets confidence. These reservescould also be used by developing countries, which areconstrained in their ability to tap private-capital marketsat a reasonable cost, to buy the needed investment goods.The effect of a general allocation would be boosted if itwere combined with a redistribution scheme that wouldput the SDRs that are allocated to the creditor countriesin a common pool.

The objectives of these proposals need, however, to bereconciled with the principles and procedures that gov-ern the allocation and the use of SDRs.

It can be questioned whether it is appropriate to use mon-etary creation (which is what an SDR allocation is allabout) to finance development. Opponents to proposalsfor using allocated SDRs to finance development havesince the creation of the SDR argued that, as a principle,considerations for the management of international li-¥1∂ Ossola (1965).

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quidity and for the transfer of real resources cannot bereconciled in a single decision (1).

The creditor countries, as main IMF shareholders, alsounderline the importance of IMF conditionality. Condi-tional financing through the normal IMF facilities ismore useful than the unconditional net use of SDR hold-ings because conditionality ensures that adjustment ac-companies financing in debtor countries. They also fearthat an SDR allocation would permit a spending spree bydeveloping countries on unnecessary goods.

The SDR mechanism is also not cost-free. As already in-dicated, members holding less SDRs than their cumula-tive allocations pay an interest rate on that negativebalance. While the interest rate charged for the use ofthose SDRs would probably be lower than the marketrates for developing countries, this charge would also besubstantially higher than the rate charged by the IMF un-der its concessional window.

Finally, an SDR allocation and/or amendment to the IMFarticles of agreement requires the acceptance of IMFmembers having 85 % of the total voting power, whichmakes it a rather lengthy, cumbersome and uncertainprocess, as shown by the equity issue allocation.¥1∂ See for example Rey and Robert (1997).

99

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110

List of contents of European Economy

Basic editions

1, November 1978• Annual Economic Report 1978–79• Annual Economic Review 1978–79

2, March 1979• European monetary system

— Texts of the European Council of 4 and 5 December 1978

3, July 1979• Short-term economic trends and prospects• The European monetary system

— Commentary— Documents


5, March 1980• Short-term economic trends and prospects• Adaptation of working time

6, July 1980• Short-term economic trends and prospects —

Borrowing and lending instruments looked atin the context of the Community’s financial instruments


8, March 1981• Economic trends and prospects —

The Community’s borrowing and lending operations recent developments

9, July 1981• Fifth medium-term economic policy programme

— The main medium-term issues: an analysis


11, March 1982• Economic trends and prospects — Unit

labour costs in manufacturing industry and in the whole economy

12, July 1982• Documents relating to the European

monetary system

13, September 1982• The borrowing and lending activities of

the Community in 1981


15, March 1983• Economic trends and prospects — Budgetary

systems and procedures — Industrial labour costs — Greek capital markets

16, July 1983• Business investment and the tax and financial

environment — Energy and the economy: a study of the main relationships in the countries of the European Community — The foreign trade of the Community, the United States and Japan

17, September 1983• The borrowing and lending activities

of the Community in 1982


19, March 1984• Economic trends and prospects —

Industrial labour costs — Medium-term budget balance and the public debt — The issue of protectionism

20, July 1984• Some aspects of industrial productive

performance in the European Community: an appraisal — Profitability, relative factor prices and capital/labour substitution in the Community, the United States and Japan, 1960–83 — Convergence and coordination of macroeconomic policies: some basic issues

21, September 1984• Commission report to the Council and to

Parliament on the borrowing and lending activities of the Community in 1983


23, March 1985• Economic trends and prospects 1984–85

24, July 1985• The borrowing and lending activities of

the Community in 1984

25, September 1985• Competitiveness of European industry:

situation to date — The determination of supply in industry in the Community — The development of market services in the European Community, the United States and Japan — Technical progress, structural change and employment


27, March 1986• Employment problems: views of businessmen

and the workforce — Compact — A prototype macroeconomic model of the European Community in the world economy

28, May 1986• Commission report to the Council and to

Parliament on the borrowing and lending activities of the Community in 1985

29, July 1986• Annual Economic Review 1986–87

30, November 1986

• Annual Economic Report 1986–87

31, March 1987

• The determinants of investment — Estimation and simulation of international trade linkages in the Quest model

32, May 1987

• Commission report to the Council and to Parliament on the borrowing and lending activities of the Community in 1986

33, July 1987

• The economy outlook for 1988 and budgetary policy in the Member States — Economic trends in the Community and Member States

34, November 1987


35, March 1988

• The economics of 1992

36, May 1988

• Creation of a European financial area

37, July 1988

• Commission report to the Council and to Parliament on the borrowing and lending activities in the Community in 1987

38, November 1988


39, March 1989

• International trade of the European Community

40, May 1989

• Horizontal mergers and competition policy in the European Community

41, July 1989

• The borrowing and lending activities of the Community in 1988 — Economic convergence in the Community: a greater effort is needed

42, November 1989


43, March 1990

• Economic transformation in Hungary and Poland

44, October 1990

• One market, one money

45, December 1990

• Stabilisation, liberalisation and devolution

46, December 1990


47, March 1991

• Developments on the labour-market in the Community — Quest — A macroeconomic model for the countries of the European Community as part of the world economy

48, September 1991

• Fair competition in the international market: Community State aid policy — The ecu and its role in the process towards monetary union

49, 1993

• Reform issues in the former Soviet Union

50, December 1991


51, May 1992

• The climate challenge: Economic aspects of the Community’s strategy for limiting CO2 emissions

52, 1993

• The European Community as a world trade partner

53, 1993

• Stable money — sound finances: Community public finance in the perspective of EMU

54, 1993

• Annual Economic Report for 1993

55, 1993

• Broad economic policy guidelines and convergence report

56, 1994


57, 1994

• Competition and integration — Community merger control policy

58, 1994

• 1994 broad economic policy guidelines — Report on the implementation of macrofinancial assistance to third countries

59, 1995


60, 1995

• 1995 broad economic policy guidelines

61, 1996


62, 1996


63, 1997


64, 1997


65, 1998

• Commission’s recommendation concerning the third stage of economic and monetary union — Convergence report 1998 — Growth and employment in the stability-oriented framework of EMU

66, 1998


67, 1999

• 1999 Annual Economic Report

68, 1999• 1999 broad economic policy guidelines

69, 1999• The EU economy: 1999 review

70, 2000• 2000 broad economic policy guidelines —

Convergence report 2000 — Proposal for a Council decision for the adoption by Greece of the single currency on 1 January 2001


72, 2001• 2001 broad economic policy guidelines


Investing in the future

Reports and studies

1-1993

• The economic and financial situation in Italy

2-1993

• Shaping a market economy legal system

3-1993

• Market services and European integration: the challenges for the 1990s

4-1993

• The economic and financial situation in Belgium

5-1993

• The economics of Community public finance

6-1993

• The economic and financial situation in Denmark

1-1994

• Applying market principles to government borrowing — Growth and employment: the scope for a European initiative

2-1994

• The economic and financial situation in Germany

3-1994

• Towards greater fiscal discipline

4-1994

• EC agricultural policy for the 21st century

5-1994

• The economics of the common agricultural policy (CAP)

6-1994

• The economic interpretation between the EU and eastern Europe

7-1994

• The economic and financial situation in Spain

1-1995

• The economic and financial situation in the Netherlands

2-1995

• Report on the implementation of macrofinancial assistance to the third countries in 1994

3-1995

• Performance of the European Union labour market

4-1995

• The impact of exchange-rate movements on trade within the single market

1-1996

• The economic and financial situation in Ireland. Ireland in the transition to EMU

2-1996

• The CAP and enlargement — Economic effects of the compensatory payments

3-1996

• Ageing and pension expenditure prospects in the western world

4-1996

• Economic evaluation of the internal market

1-1997

• The economic and financial situation in Portugal in the transition to EMU

2-1997

• The CAP and enlargement — Agrifood price developments in five associated countries

3-1997

• The European Union as a world trade partner

4-1997

• The welfare state in Europe — Challenges and reforms

5-1997

• Towards a common agricultural and rural policy for Europe

6-1997• The joint harmonised EU programme of business

and consumer surveys

1-1998• Getting environmental policy right —

The rational design of European environmental policy

2-1998• The economic and financial situation in Austria

3-1998• Income benefits for early exit from

the labour market in eight European countries — A comparative study

1-1999• The economic and financial situation in Finland

2-1999• Income insurance in European agriculture

3-1999• State aid and the single market

4-1999• Liberalisation of network industries

5-1999• Italy’s slow growth in the 1990s

6-1999• Generational accounting in Europe

1-2000• The report on the implementation of

the 1999 broad economic policy guidelines

2-2000• Public debt and fiscal policy in EMU

3-2000• Public finances in EMU — 2000

4-2000• Performance of the European Union labour

market — Joint harmonised EU programme of business and consumer surveys

1-2001

• Current issues in economic growth

2-2001

• Report on the implementation of the 2000 broad economic policy guidelines

3-2001

• Public finances in EMU — 2001

4-2001

• The budgetary challenge posed by ageing populations

5-2001

• The efficiency defense and the European system of merger control

Special editions

Special issue 1979• Changes in industrial structure in the European

economies since the oil crisis 1973–78 — Europe — its capacity to change in question

Special edition 1990• The impact of the internal market by industrial

sector: the challenge for the Member States

Special edition No 1/91• The economics of EMU

Special edition No 2/91• The path of reform in central

and eastern Europe

Special edition No 1/92• The economics of limiting CO2 emissions

New numbering

2002

1-2002• Report on the implementation of the 2001

broad economic policy guidelines

2-2002• Economic forecasts — Spring 2002

Special Report No 1/2002• Responses to the challenges

of globalisation

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Special report No 1 / 2002

ISSN 1684-033X

EUROPEANECONOMY

EUROPEAN COMMISSIONDIRECTORATE-GENERAL FOR ECONOMIC

AND FINANCIAL AFFAIRS

Responses to the challenges of globalisation

EURO

PEAN

ECON

OM

YSp

ecia

l Rep

ort N

o 1

/ 2002

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