Introduction

As highlighted in Chapter 4 of this volume, lower-income developing countries are not fully integrated in the global financial system. They are not only under-represented in major decision-making forums; they also remain largely excluded from the flow of substantial private external financing. To correct this architectural weakness, the international community has stepped in to provide substantial amounts of bilateral and multilateral official financing, either through grants or concessional lending. This concessional official financing – generally described as ‘development aid’ – makes up the lion's share of external capital flows to low-income countries (see Chapter 4, Table 4.1). The aid architecture thus remains an important subset of the global financial architecture. It can be defined as the set of rules and institutions affecting aid flows, including the way aid is allocated, the modalities through which it is delivered and its accompanying conditionality requirements.

Although only loosely linked to changes in the overall global financial architecture, the aid system over the last few years has been witnessing a transformation, with policy changes at both the bilateral and multilateral donor levels and actions at the level of individual recipient countries. Overall, these changes aim to considerably improve the effectiveness of aid, to the extent that aid scholars refer to a ‘paradigm shift’ (Renard 2006). We thus aim to document how changes in this subset of the overall international financial architecture have affected actual behaviour.

Introduction

As discussed in the introductory chapter of this volume (Underhill, Blom and Mügge), across-the-board G7/G10 and IFI pressure for increased capital mobility and capital account openness has been a central feature of the (new) global financial architecture, a policy prescription which a wide range of developing countries have adopted. This chapter critically examines the relationship between financial integration/openness and financial development and, in turn, economic development. In doing so, it evaluates the effectiveness of this input side push towards financial openness to produce (as its output) successful economic development in developing countries.

The belief in the virtues of capital mobility – and the determination with which it is translated into policy advice at the global level (see Baker's chapter in this volume) – is grounded in standard theoretical economic analysis. In theory, financial development should be good for growth as it allows for the efficient mobilisation of savings for productive investments. Furthermore, the development of banks and other financial intermediaries increases the average productivity of capital by reducing problems of adverse selection and moral hazard. Financial openness should enhance financial development, while standard neoclassical growth theory also predicts huge gains for developing countries from financial market integration. Differences in the capital-labour ratio provide scope for increased efficiency in the global allocation of capital. Furthermore, there is scope for improved international risk-sharing and capital deepening.