HOW LONG WILL DEVELOPING ECONOMIES WITHSTAND GLOBAL ECONOMIC CRISIS?

SUMAIRA FAZAL
Jan 26 - Feb 01, 2009

The global financial crisis is already causing a considerable slowdown in most developed countries. Governments around the world are trying to contain the crisis, but many suggest the worst is not yet over. Stock markets are down more than 40% from their recent highs. Investment banks have collapsed, rescue packages are drawn up involving more than a trillion US dollars, and interest rates have been cut around the world in what looks like a coordinated response. Leading indicators of global economic activity, such as shipping rates, are declining at alarming rates.

Many developing economies are still growing strongly, but forecasts have been downgraded substantially in the space of a few months. The current financial crisis affects developing countries in two possible ways. First, there could be financial contagion and spillovers for the stock markets in emerging markets. The Russian stock market had to stop trading twice; the India stock market dropped by 8% in one day at the same time as stock markets in the USA and Brazil plunged. Stock markets across the world developed and developing have all dropped substantially since May 2008. We have seen share prices tumble between 12 and 19% in the USA, UK and Japan in just one week. We need to better understand the nature of the financial linkages, how they occur (as they do appear to occur) and whether anything can be done to minimize contagion. Second, the economic downturn in developed countries may also have significant impact on developing courtiers. There are various channels of impact on developing countries.

REMITTANCES TO DEVELOPING COUNTRIES WILL DECLINE. There will be fewer economic migrants coming to developed countries when they are in a recession, so low remittances and also probably lower volumes of remittances per migrants will take place.

FOREIGN DIRECT INVESTMENT AND EQUITY INVESTMENT: These come under pressure. While 2007 was a record year for FDI to developing countries, equity finance is under pressure and corporate and project finance is already weakening.

COMMERCIAL LENDING: Banks under pressure in developed countries may not be able to lend as much as they have done in the past. Investors are, increasingly, factoring in the risk of some emerging market countries defaulting on their debt, following the financial collapse of Iceland. This would limit investment in such countries as Argentina, Iceland, Pakistan and Ukraine.

AID: Aid budgets are under pressure because of debt problems and weak fiscal positions, e.g. in UK and other European countries and in the USA. While the promises of increasing aids at the Gleneagles summit in 2005 were already off track just three years later, aid budgets are now likely to be under increased pressures.

OTHER OFFICIAL FLOW: Capital Adequacy ratios of developing financial institutions will be under pressure. For example, in Pakistan, many banks are finding it difficult to comply with the State Bank's new instruction to maintain Minimum Capital Adequacy Ratio (MCAR) at 10% as against 8% previously.

Each of these channels needs to be monitored, as changes in these variables have direct consequences for growth and development. Those countries that have done well by participating in the global economy may also lose out most, depending on policy responses, and this is not the time to reject globalization but to better understand how to regulate and manage the globalization processes for the benefit of developing countries. The impact on developing countries will vary. It will depend on the response in developed countries to the financial crisis and the slow down, and the economic characteristics and policy responses, in developing countries.

WHICH COUNTRIES ARE AT RISK AND HOW?

Crisis affected export oriented countries such as USA and EU (either directly or indirectly).

Zambia would eventually be hit by lower copper prices, and the tourism sector in Caribbean and African countries will be hit.

With fewer bonuses, Indian and Pakistani workers in the city of London, for example, will have less to remit. There will be fewer migrants coming into the UK and other developed countries, where attitudes might harden and job opportunities become scant.

Countries heavily dependent on FDI, portfolio and DFI finance to address their current problems (e.g. South Africa cannot afford to reduce its interest rate, and it has already missed some important FDI deals).

Countries with sophisticated stock markets and banking sectors with weakly regulated markets for securities.

Countries with a high current account deficit with pressures on exchange rates and inflation rates. South Africa cannot afford to reduce interest rates as it needs to attract investment to address its current account deficit. Pakistan has seen devaluation as well as high inflation. Import values in other countries have already weakened the current account.

Countries with high deficits. For example Pakistan has weak fiscal position.

Countries which are dependent on aid.

While the impact will vary from country to country, the economic impacts could include:

Weaker export revenues;

Further pressures on current accounts and balance of payments;

Lower investment and growth rates;

Lost employment;

And there could also be social impacts:

Lower growth translating into higher poverty;

More crime, weaker health systems and even more difficulties meeting the Millennium Development Goals.

POSSIBLE POLICY RESPONSES:

The current macro economic and social challenges posed by the global financial crisis require much better understanding of appropriate policy responses. There needs to be a better understanding of what can provide financial stability, how cross-border cooperation can help to provide the public good of international financial rules and systems, and what the most appropriate rules are with respect to development. And there needs to be an understanding of whether and how developing counties can minimize financial contagion. Developing countries will also need to manage the implications of the current economic slowdown.