Throughout this crisis that has so consumed the attention of the world in recent months, we have watched with grave concern as it cascaded outwards from the sectors originally affected. Instability has surged from sector to sector, first from housing into banking and other financial markets, and then on into all parts of the real economy. The crisis has surged across the public-private boundary, as the hit to private firms' balance sheets has now imposed heavy new demands on the public sector's finances. It has surged across national borders within the developed world, as the people of Iceland know all too well. And now there are reasons to fear that the crisis will swamp emerging markets and other developing countries, cutting into the considerable economic progress of recent years.
Impact on developing countries
One effect will be a substantial reduction in their exports, as the rapid pace of trade expansion of this decade decelerates sharply. The IMF recently projected growth in world trade volumes of just 4.1 % in 2009, down from 9.3 % as recently as 2006; in our own more recent projections, the deceleration is much more rapid and could in fact lead trade volumes to fall in 2009 (World Bank Forthcoming). While the fall in export volume growth is projected to be greater for advanced economies than for developing economies, the latter may also suffer more from declines in the terms of trade – especially in the case of commodity exporters, given that we expect non-oil commodity prices to fall by perhaps one-fifth in 2009.
A group of Chinese migrant workers return home after they were laid off from the factories in southern China's Guangdong province in Xian, northern China's Shaanxi province . China's factory output abruptly weakened in October, due to the global crisis. AFP
In addition, the crisis will deal a negative shock to investment in emerging markets. All of the main external sources of funds for investment are likely to drop off sharply in the first round of effects. Portfolio investment will fall, as greater risk aversion keeps capital closer to home. While FDI is historically more resilient to shocks, it too is expected to decline. In addition, developing countries that are able to gain access to capital will pay higher interest rates, because of the flight to safety and greater risk aversion of lenders. As noted above, the global slowdown will reduce demand for commodities and manufactured goods, cutting into export earnings. And as labour markets slacken, foreign workers are likely to suffer disproportionate impacts on their earnings, which will reduce remittances. About half of all developing countries have been running current account deficits of 5 % of GDP or more, and in some cases the deficits are around 10 %. These economies will be highly vulnerable to swings in these various sources in external financing. Overall, we now expect investment in middle-income countries in 2009 to grow at less than half the 2007 rate of 13 %.
Second round effects will likely deepen the slowdown. Because of the investment surge of the past five years, an especially large number of investment projects are already underway. As investment financing drops off, two outcomes are possible, neither of them attractive. In some cases, the projects will not be completed, making them unproductive and saddling banks' balance sheets with non-performing loans. In other cases, when the projects are completed, they will add to the excess production capacity that will result from the global slowdown, and thereby add to the risk of deflation.
As a result of all these factors, we now expect that developing countries' collective GDP growth will decline to less than 5 %, compared with an average of more than 7 % in 2004-07. Moreover, the effects on developing countries may not be limited to a drop in investment and export earnings and a slowdown of GDP growth. There is a distinct danger that emerging markets could go through crises of their own, for example if their own domestic asset-market bubbles burst (or even if fair-market values collapse) and weaken their own banking sectors.
Many developing countries enter this crisis with advantages that they lacked during the shocks of the 1980s or 1990s. The strengthening of macroeconomic policies – including fiscal and external positions, in many cases – leaves them less vulnerable.
The first priority is to prevent financial contagion from crippling domestic banking and non-banking financial sectors. Because of the high level of interlinkages among the world's financial firms and sectors, these effects have begun to arrive before the real-economy effects in some countries. Stock markets have declined sharply, some currencies have depreciated substantially, and sovereign interest-rate spreads have risen with the "flight to safety" in world markets. At a more micro level, some developing-country exporters are already finding it hard to obtain the trade credits that are their lifeblood, which could cripple export sectors that will soon be hit by the fall in foreign demand.
So just like in the developed countries, it is important that the developing countries take quick, decisive, and systematic measures to ensure that credit crunches and bank collapses are avoided locally. And in extending deposit guarantees, governments need to set adequate floors and coordinate policies to avoid "beggar-thy-neighbour" policies, while guarding against the long-run moral hazard effects that will make the regulators' job harder in the future.
Developing countries that enter the crisis with large balance-of-payments and fiscal deficits will be the most vulnerable to these effects. Such countries will have larger financing and adjustment needs, if the current account swings sharply from deficit to balance as capital dries up, as occurred in the Asian financial crisis. This will put a deep strain on the balance sheets of domestic firms and banks, potentially leading to a cascade of bankruptcies and bank failures. If their fiscal resources are already strained to the limit, then it may be impossible to mount domestically financed rescues of their financial sectors. These countries will likely have to seek financing for the international financial institutions, especially at a time when bilateral donors are already straining to meet domestic crisis needs.
More generally, developing-country governments have two main macroeconomic tools for responding to the negative shock that is coming their way: monetary policy and fiscal policy. One great risk is that if the credit crisis is not effectively resolved, the global economy could enter a period of deflation like the one that Japan suffered through in the 1990s. In that environment, standard monetary policy will not likely be effective in the developed economies.
Firms in these countries are already on or near the global technological frontier, so there is limited room for industrial upgrading, meaning that any credit-financed expansion would primarily be in terms of production capacity. But in the face of low demand and excess capacity, developed country firms are not likely to want or be able to borrow to finance expansion.
In the developing world, by contrast, there is more room for credit-financed industrial upgrading, which may give more room for monetary policy to work in those countries that can afford to use it. Not all countries will be able to; some may find themselves forced to tighten monetary policy and increase interest rates to prevent excessive currency depreciation or capital outflows.
On the fiscal-policy side, developing-country governments have a variety of tools that they could use to cushion the blow of the shock. Governments with some fiscal space can respond by injecting some well-designed fiscal stimulus into their economies, to generate domestic demand that can offset the expected decline in foreign demand. Developing countries have pressing needs that can be met through public investments. One such need is building of infrastructure, especially after a period when private-sector growth has sometimes outstripped the ability of the public sector to provide the infrastructure needed to sustain that growth and rural infrastructure where the infrastructural gap exists between urban and rural areas.
A second area for investment is social protection and human development, to ensure that a temporary shock is not converted into severe permanent declines in welfare of poorer households. There are many programmes that have been shown in evaluations to be worth investing in; governments should prioritize protection and expansion of those that most effectively buffer the impact of crises on the poorest households.
In the short time since the financial crisis went global, a great deal has already been written about how developed countries should respond to the global credit crisis. A preponderance of expert opinion soon formed around core recommendations – that governments recapitalize banks and provide further guarantees on bank deposits and loans that have already become policy in the European Union and the United States. Given the brainpower that is already devoted to the developed-country response, I have focused my recommendations primarily on developing economies and IFIs.
So many developing countries have gone through recent financial crises of their own – including the global debt crisis of the 1980s, the "tequila crisis" of the mid-1990s, and the Asian financial crisis of 1997/98 (which quickly spread to other emerging markets) – that the development literature includes some valuable lessons about how to resolve them.
One such lesson concerns the importance of rapidly reaching social consensus on how losses are to be shared. Without such an agreement, the economy can become mired in social conflict and prevented from moving forward with reform.
A second set of recommendations concerns developed-country policies that may directly affect the developing world's ability to respond to crisis. Given the likely economic costs of the crisis and the certain immediate fiscal costs of the public sector response, governments will likely feel pressure from taxpayers and voters to raise trade barriers and possibly reduce international aid. But giving in to those pressures would exacerbate the pressures on the developing world and risk contributing to a vicious cycle. Resisting protectionist pressures will be particularly important, after a period during which the developing world sharply expanded its interdependence with the global economy.
(Excerpts of a presentation made at the Korea Development Institute, Seoul on October 31)