Capital markets in the South remain fragmented and very imperfect. Besley discusses Gershenkron's conjecture (1962) about the relation between economic development and the development of financial intermediaries, which is supported by data assembled by Goldsmith (1969), who has discovered that the ratio of the value of financial instruments to wealth rises during economic development. This evolution, which had been held back as governments seized control of the "commanding heights of the economy", should unfold rapidly now that capital markets are being liberalized.

# 9.5) Foreign Capital and Its Intermediation

Chapters by Eaton, Cardoso, and Dornbusch and Helleiner discuss North-South capital flows and review their history. Jimenez's and Krueger's chapters examine how effectively planners allocate foreign capital and domestic saving to profitable investment opportunities.

Eaton provides a cogent overview of the relevant theory. Reading him, one cannot avoid pondering the fact that the North-South flow of private investment remains very low in view of factor scarcities in the two parts of the world. The stock of Northern funds in the South is not insignificant, it is true, and Cardoso and Dornbusch36 note that it amounted to 30 percent of US GNP in 1987; only 15 percent was foreign investment however. Expanding this stock could accelerate development. Even today<sup>37</sup> , world capital flows are much smaller in proportion to GNP than before the first World War. An upsurge followed the first oil shock, but this ended in disaster in Latin America and in countries such as Morocco, which borrowed to postpone adjustment, but countries that managed their affairs recovered rather fast from the 1982 debt shock.

The gradual vanishing of the foreign exchange constraint that the two gaps model highlighted has improved the South's ability to absorb foreign capital. In 1962, the year of publication of Chenery and Bruno's seminal article, Cairncross38 already wondered whether it is appropriate to view a shortage of foreign exchange as a limiting factor in development, as distinct from a shortage of production factors. One of the important changes in the first half century of development has been -- with hiccups such as the current one -- the gradual softening of this constraint. Exports of manufactures have opened up markets that were more expandable than those for primary commodities. After the first oil shock, developing countries began to borrow from private sources; because of poor economic management, this ended in disaster for some, but Asian countries went through the debt shock with little damage. And now (thanks to generous balance of payments support that was quickly reimbursed), Latin America has gone through the second Mexican crisis with little lasting damage. Tropical African countries and some others are still of course in a foreign exchange straight jacket, but most of the South are gradually becoming able to deal with macroeconomic shocks as Northern countries do. This reduces the risk of investing in the developing world, and should expand the North-South flow of capital. The process must be gradual, because of complex problems of custody and investment protection against fraud and seizure that remain to be solved, not to mention corruption.

36 1:26:1388.

37 Taylor (1997).

38 Chenery and Bruno (1962) and Cairncross (1962), cited by Srinivasan (2:1143).

24