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THE FINANCIAL CRISIS AND ITS
IMPACT ON DEVELOPING COUNTRIESWORKING PAPER
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Copyright January 2009
United Nations Development Programme
Bureau or Development Policy
Poverty Group
304 East 45th Street
New York, NY, 11375
U.S.A.
www.undp.org/povertyE-mail: [email protected]
Abstract
This working paper has been commissioned by the Poverty Group, Bureau or Development
Policy at UNDP, to identiy the transmission mechanisms o the nancial crisis rom developed
to developing countries and to provide broad policy recommendations at the national,
global and regional level. The paper identies three mechanisms that play a key role in
spreading the consequences o the nancial crisis to the developing world: remittances,
capital ows and trade. The policy responses take MDG achievement and poverty reductionas the central policy concern. The paper indicates that a air number o countries have policy
space to protect vulnerable groups in the short run as well as to undertake investments
to build resilience and reach these goals in the longer term. Other countries will need
additional development assistance to protect development achievements. The authors
point to a number o actors that need to be taken into account in determining what mix o
policies to deploy including the macroeconomic, scal and policy stance o countries and
their dynamics. The paper also proposes ar-reaching reorms to address the global nancial
crisis, which would help to put the global macroeconomic, scal and nancial coordination
mechanisms on a rmer ooting.
Disclaimer
The views expressed in this publication are those o the authors and do not necessarily
represent those o the United Nations, including UNDP, or their Member States.
http://www.undp.org/povertymailto:[email protected]:[email protected]://www.undp.org/poverty8/3/2019 UNDP - The Financial C
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THE FINANCIAL CRISIS AND ITS
IMPACT ON DEVELOPING COUNTRIES
Stephany Grith-Jones and Jos Antonio Ocampo
Working Paper, January 2009
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Contents
Acronyms .......................................................................................................1
Executive summary ....................................................................................2
IntroductionI. ...................................................................................... 5
Channels o transmission o the crisisII. ................................... 5
RemittancesA. .................................................................................................................... 5
Capital FlowsB. .................................................................................................................. 6
TradeC. ................................................................................................................................ 8
Policy ResponsesIII. ............................................................................10
National responsesA. .....................................................................................................10
Global responsesB. ..........................................................................................................13
Correcting the regulatory defcit o global fnance1. ............................................. 13
IMF Reorm2. .................................................................................................................. 14
Coordination o global macroeconomic policy or growth and poverty3. ............
reduction ..................................................................................................................... 15
Regional responses unded by developing countriesC. .......................................... 16
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CIS Commonwealth o Independent States
ESF Exogenous Shocks Facility
FDI Foreign Direct Investment
IDA International Development Association, a World Bank
lending arm to low-income countries
IIF Institute o International Finance
IMF International Monetary Fund
MDBs Multilateral Development Banks
MDGs Millennium Development Goals
NICs Newly Industrialised Countries
ODA Ocial Development Assistance
OECD Organisation or Economic Cooperation and Development
PRC Peoples Republic o China
PRGF Poverty Reduction and Growth Facility
SDRs Special Drawing Rights
SLF Short-Term Liquidity Facility o IMF
UNCTAD United Nations Conerence on Trade and Development
UNDP United Nations Development Programme
Acronyms
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The current economic and nancial crisis was driven by the reversal o the three positive
shocks that developing countries experienced during the recent boom period: exceptional
nancing, high commodity prices and, or a signicant number o countries, large ows o
remittances. The initial trigger that contributed to the reversals o these trends was the impact
o the bursting o the U.S. housing bubble. However, it was the reversal in commodity prices
in mid-2008 and, particularly, the severe world nancial crisis that started in September 2008
that led to signicant reversal o avorable global conditions or developing countries. The
emerging recession in the United States and other developed countries urther multiplied
the negative impact o the crisis or developing countries.
Transmission Mechanisms
One o the key channels or transmission o the crisis rom developed to developing
countries has been via private capital ows though the impact o this has been moresevere or emerging markets than or low-income countries, which are less integrated into
international private capital markets. In several countries, there has been a massive reversal
o currency positions out o high-yielding assets in emerging economies into developed
countries currency with a negative impact on the exchange rates o developing countries,
even in countries with signicant current account surpluses. While FDI ows have not been
signicantly afected to date, with the decline in commodity prices, FDI ows into those
sectors will likely all sharply. Ocial development assistance (ODA) is estimated at $104
billion in 2007. A key challenge is or aid ows to augment at the very least according to
existing commitments, though i the recession in the developed countries is very serious,there is a risk that aid budgets may not increase enough or could even all, with negative
efects on poor countries and poor peoples.
The main channel o transmission o the crisis to exporters o manuactures and services
is through a decline in trade volumes; while exporters o primary goods have been more
afected by declining prices. Falling energy prices will benet energy importing countries but
they will also lead to reduced investment and economic activity in commodity-dependent
developing countries, particularly in Arica, the Middle East and North Arica, and Latin
America. For these countries, a major opportunity ahead is to redesign their trade strategy
to reduce their commodity dependence.
National Responses
Countries with stabilization unds (generally, energy exporters and some metal exporters)
will be able to use past savings to cushion the efect o commodity price downswings.
Broadly, national responses should aim to mitigate the contractionary efects coming
rom abroad and to rethink their trade strategies. The nature o the policy packages to be
adopted will vary. For those countries with a strong debt and oreign exchange reserve
position but weak scal stance the room or maneuver lies more in monetary than with
scal policy. Most emerging economies have the capacity to avoid the traditional pro-cyclical monetary policies o past crises and ollow the expansionary policy trajectories o
industrial economies. In the scal area, there is signicant room to maneuver in a relatively
Executive summary
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large group o developing countries. They should use this space to mitigate the efects o the
external shock. Inrastructure investment and social spending should be the ocus o these
programs.
The strategy will also depend on each countrys social policy ramework. Universal
social policies in the areas o nutrition, basic education and health should be the major policy
ocus, but targeted programs or the poor, such as conditional cash transers, make sensein middle-income countries (in poorer countries, by denition, poverty is widespread and
universal programs are clearly superior). Special emergency employment programs should
be the essential complement, since unemployment insurance, the traditional automatic
stabilizer o industrial countries is generally absent in developing countries. Tax reduction
policies are unlikely to have the best efects. Trade policy can play a role in the recovery in
at least three diferent ways: i) non-traditional exports can be encouraged through a mix
o exchange rate depreciation and sectoral incentives; ii) strengthening domestic linkages
o existing manuacturing export activities can also play a role; and iii) more active South-
South cooperation may encourage trade through existing integration processes. Payments
agreements among central banks can also play a role in acilitating such trade without theneed or hard currencies.
Global Responses
The magnitude o the current crisis is clearly associated with inadequate regulation and
supervision o banks and nancial markets. The new regulatory governance needs to be
based on a well-unctioning network o national and regional authorities and include truly
international supervision o nancial institutions with a global reach. The institutional
structure that responds to this challenge should have adequate representation rom
developing countries to ensure not just greater legitimacy, but also greater eciency. Thereare a number o broad principles on which uture nancial regulation needs to be built: the
rst is counter-cyclicality, in order to correct the main market ailure o banking and nancial
markets - their boom-bust nature. The second key principle or modern, efective regulation
should be comprehensiveness; or regulation to be efective, the domain o the regulator
has to be the same as the domain o the market to be regulated.
The global recession now under way calls or a coordinated policy response. It means
expansionary monetary, credit and scal policies in all industrial countries. Developing
countries should adopt equally expansionary policies, individually and in a coordinated
way. Countries that have accumulated large amounts o oreign exchange reserves and havelimited external debt ratios do have a larger room or maneuver to adopt these policies. For
others it is essential to avoid the IMF conditionalities o the past, which orced developing
countries to adopt contractionary macroeconomic policies.
Four essential reorms o the IMF should be part o the reorm agenda: i) the creation
o a meaningul and truly global reserve currency, ii) the need to place the IMF at the center
o global macroeconomic policy coordination giving greater voice to developing countries;
iii)the need or the IMF to lend during balance o payments crises rapidly, at sucient scale,
and without overburdening borrowers with conditionalities o the past, particularly when
the sources o the crisis are exogenous.
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Regional Responses Funded by Developing Countries
In all o the areas o reorm, the IMF should collaborate more closely with regional institutions,
such as the Chiang Mai1 Initiative or the Latin American Reserve Fund2 . Developing countries
are also in an excellent position to contribute to this task, given their large oreign exchange
reserves. Additionally, many developing countries have created sovereign wealth unds with
an additional level o assets o more than $3 trillion. Further, swap arrangements among
central banks, pooling them in reserve unds or or support o the development o regional
bond markets, are mechanisms to multiply the room to maneuver that they provide.
While multilateral development banks should maintain their central unction in the
international development architecture, regional and sub-regional nancial institutions
owned by developing countries should play an important complementary role. I developing
countries allocate even 1% o their oreign exchange reserves they could create or expand
existing regional institutions by $50 billion at current levels o reserves, laying the basis to
meet their development goals more eciently.
1The Chiang Mai Initiative (CMI) is an initiative under the ASEAN+3 ramework. Ater 1997 Asian Financial Crisis
member countries started this initiative to manage regional short-term liquidity problems.
2The Latin American Reserve Fund, is a multilateral organization ormed by the central banks rom Bolivia, Colom-
bia, Costa Rica, Ecuador, Peru and Venezuela.
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change as a result o the steep all in oil prices. Overall, the World Bank has estimated that
remittances to the developing world experienced a lower, but still positive and airly strong
growth in 2008 (7% in 2008 vs. 16% in 2007). However, in 2009 they will ace a reduction -
either small (-1%) or large (-6%) (Ratha et al., 2008).
Overall, remittances are likely to show resilience and are, thereore, unlikely to be a
major channel o transmission o the crisis. However, should the recession become deep and
prolonged, the efects on remittances could deepen.
Capital FlowsB.
In contrast, one o the key channels or transmission o the crisis rom developed to developing
countries is via private capital ows. The efects take place both through volumes and
associated costs o such ows. Vulnerability o developing countries to rapid deterioration
in capital ows has been diminished by the act that, as a result o their good policies, many
o these countries have ar higher levels o oreign exchange reserves and lower levels o
external debt than in the past. As we will see below, they can help to cushion countries rom
a deteriorating international environment, but the space it provides or counter-cyclicalmacroeconomic policies remains to be seen. Emerging market investors (both public and
private) have also become an important source o capital ows to developing countries. We
return to this issue below, in our policy section.
At the same time, new sources o vulnerability have opened up, such as the volatility
o portolio investments made into the growing domestic capital markets o developing
countries and the rapid unwinding o carry trade3 (this trade was mainly done using
instruments rom the rapidly growing derivative markets). Also, increased oreign ownership
o developing country banks has not proven to be a source o strength, and in some cases
may turned out to be a source o ragility, as these banks have withdrawn lending to their
subsidiaries in developing and transition countries in order to strengthen their very weak
positions in developed countries.
As regards volumes o ows, oreign direct investment continued to grow through
2008. Private nancial ows peaked rom mid-2006 to mid-2007. Ater a short weakening
during the third quarter o 2007 due to the sub-prime crisis, they recovered and boomed
again during the rst semester o 2008 but dropped very sharply since the third quarter o
2008 and became negative in some cases during the last quarter o the year. Emissions in
bond markets came to a halt, bank lending was severely hit, and there was a sharp reversalo ows rom mutual unds and an unwinding o the carry trade (urther details below). On
annual terms, nancial ows peaked in 2007 and ell in 2008. They are widely expected (e.g.
by the IMF, the United Nations and the Institute o International Finance - IIF) to all urther
in 2009.4
In terms o the cost o nancing, although spreads or emerging market bonds have
been increasing since mid-2007, this efect was largely counteracted by the reduction o
3
The phrase carry trade became widely popular in the context o currency speculation. The search or yield impliesthat the excess liquidity surging out o the low-interest currencies is invested into high-yielding currencies. When
the process reverses, investors pull out high-yielding currencies, which they ear would depreciate and retreat back
to the sae haven o the low-interest-rate currencies (Frankel, 2008).
4United Nations (2009), Chapter III. For annual fgures by region, see in particular Table III.2.
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reerence interest rates (generally the 10-year U.S. Treasury bond), so that yields did not
show a strong upward trend. It was only in June 2008 that yields increased substantially and
exploded ater the global nancial meltdown o mid-September 2008.
This behavior o the quantity and price o nancial ows has been a major mechanism
transmitting movements in stock markets rom industrial to developing countries. On
average, when measured in dollar terms, stock markets have experienced a strongercontraction in emerging markets since their peak in late October - early November 2007
than stock markets in industrial countries.
This impact o the global nancial crisis has been more severe or emerging markets
than or low-income countries, which are less integrated into international private capital
markets. Indeed, capital ows to low-income Arica have been relatively limited. It is
unortunate, nonetheless, that the bond issuance that some Sub-Saharan Arican countries
had begun to make has also stopped. Hardest hit were the transition economies o Central
and Eastern Europe, where the combination o adverse expectations generated by large
current account decits, high vulnerability o the domestic nancial system, or both, led torapid withdrawals o private capital ows. The reversal o portolio ows in East and South
Asia was large and even surprising in several cases. For South Korea, or example, the Institute
o International Finance estimates that oreign investors withdrew a massive net $45 billion
in 2008. Countries like India and Taiwan (PRC) also saw negative portolio investment ows.
In Latin America, Brazil and Mexico were hit by losses in derivative markets and, in the rst
case, by the unwinding o the carry trade. South Arica was also severely hit.
Concerning categories o private ows, a major source o problems in late 2008 was
the interruption o bond issues in international capital markets (some were done, though in
limited quantities, in early 2009) and the severe slump in inter-bank lending, both phenomenabeing part o a worldwide reeze in nancing. Trade credit has been an important casualty o
this drop. Some countries, like Brazil, have been able to put their oreign exchange reserves
to good use by supporting exporters that have no access to international private trade credit
lines. However, the IIF and others rightly ear that net bank lending to emerging markets
will remain lower or some time, as bank capital will restrain banks ability and willingness
to lend. According to IIF gures, bank lending to emerging markets ell rom a peak o $410
billion in 2007 to $167 billion in 2008. Even more worrisome, it is projected by the IIF to all
to minus $ 60 b billion in 2009.5
A second source o problems is the high level o aggregate amortizations due byprivate sector borrowers, which are projected to reach $130 billion in the rst hal o 2009
and $250 billion or the whole o 2009, i both loans and syndicated bonds are added. More
signicantly, some emerging countries greatly increased their short-term borrowing in 2007
and 2008, which seems to leave them very vulnerable to a reversal o these short-term ows.
South Korea and Russia had particularly large short-term inows, and their reversal has been
a source o serious problem or their economies.
The other category o highly problematic capital ows is net ows rom non-bank sources
such as mutual and hedge unds. Withdrawals rom mutual unds in industrial countries and
the unwinding o carry trade since July 2008 led to a massive reversal o currency positions
5See the latest Capital Market Monitor o this organization in www.ii.com
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out o high-yielding assets in emerging economies into developed countries currency. This
phenomenon has had a major negative impact on exchange rates o developing countries,
even in countries with signicant current account surpluses. It also shows how some
categories o private rms are almost totally driven by internationally-determined actors,
such as the global risk aversion, and ar less by the economic undamentals o countries.
The IIF estimates that short-term speculative carry trade positions are much reduced(in contrast to bank exposures that remain substantial) and, or this reason, it projects non-
bank private debt ows to rebound in 2009. However, the transparency o these positions
and rms is quite limited, as most o these transactions do not operate over the exchanges
and have no or limited reporting requirements (see, or example, Grith-Jones and Dodd,
2008).
Foreign direct investment ows have been relatively more stable. However, the most
recent UNCTAD Investment Report (UNCTAD, 2008) estimates that FDI to emerging markets
declined by 10% in 2008, whilst the OECD estimates a ar sharper decline. The decline in
real estate and, especially, commodity prices seem to make it more likely that FDI ows intothose sectors will all sharply. This could have particularly strong negative impacts on FDI to
Latin America and Arica.
Ocial capital ows show a very diferent pattern. Ocial development assistance
(ODA) increased since the Monterrey Conerence on Financing or Development, rom $57
billion in 2002 to a peak o $107 billion in 2005 (including debt relie), but slightly declined
since then, to an estimated $104 billion in 2007. A key challenge is or aid ows to augment
at the very least according to existing commitments, and there is a strong argument to
increase them urther. This is especially necessary given that poor developing countries will
be hit by a number o external shocks related to the crisis, which will endanger their growthand their ability to meet poverty reduction targets. Nevertheless, i the recession in the
developed countries is very serious, there is a risk that aid budgets may not increase enough
or could even all, with negative efects on poor countries and poor peoples.
Other orms o ocial capital ows stand in open contrast to this trend in ODA. First,
some developing countries with active sovereign wealth unds and/or public sector rms
have been actively investing abroad. This has led to net negative ocial ows to developing
countries. This is particularly true o the oil-exporting countries o Western Asia. Second, an
even larger negative ow is associated with oreign exchange reserve accumulation, which
is generally reected in investments in sae assets rom reserve currency countries. Andthird, in recent years major multilateral development banks have experienced diculties
in nding a demand or their lending, and some countries have actually paid back some o
their debts to these institutions. The crisis has generated a large demand or these ows,
reecting the counter-cyclical role that this type o nancing should have. However, the
magnitudes involved are relatively small, in the order o billions rather than the tens and
hundreds billions that characterize net changes in private sector nancing. This gap indicates
the need or much larger ocial unds that those currently available.
TradeC.In recent decades, world trade has shown two important characteristics. First o all, it has
tended to expand more rapidly than world production, a process that has been accompanied
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by a rapid diversication in the trade structure. Thus, during the recent boom, in 2003-2006,
world trade grew at an annual rate o 9.3%, more than twice the rate o growth o world
output (3.8%). Second, these rates o growth have been highly elastic to world output
through the business cycle and have, thereore, been more volatile than world production.
A major implication o this characteristic is that, although trade enhances world business
cycle upswings, it equally tends to multiply downswings. Trade volumes contracted in 2001
and will again contract in 2009. The growth o trade volume experienced a strong slowdownsince mid-2007, to a rate o around 2% by September 2008. This rate turned negative in
November and December i we are to judge rom reports that indicate that even China,
the most dynamic world exporter, experienced negative export growth and even sharper
negative import growth in those months.
While this recession in trade volumes will be the main channel o transmission o the
crisis to exporters o manuactures and services (tourism being a major service export or
many developing countries), price developments will dominate the export perormance o
exporters o primary goods.
In recent years, the world economy experienced the most impressive commodity boom
in more than a century, both in terms o duration (ve years), intensity and product coverage
(World Bank, 2009, chapter 2). The boom was more pronounced or minerals, including oil
and other energy products, than or agricultural goods. This is reected in the act that
whereas at the peak around the second quarter o 2008 the real prices o minerals exceeded
the average o the 1970s by considerable margins (more in the case o energy products but
also signicantly in the case o metals), real agricultural prices went only briey back to the
level o the 1970s. It was, in other words, a boom o mineral, not agricultural prices (Ocampo
and Parra, 2008). A major reection o this act is that, whereas the terms o trade o mineral
exporting countries improved signicantly, those o agricultural exporters remained at and
those o manuacturing exporters deteriorated (United Nations, 2009, Figure II.6).
This diference seems to reect diverse determinants behind the associated price
trends among commodity groups. For mineral exports, the dominant issue has been the
underinvestment generated by a long period o low prices over the last two decades o the
twentieth century. Given the higher demand propelled by rapid growth in the developing
world and specically, the high demand o China or metals, prices boomed. Investment
increased, but there were signicant lags in the transormation o new projects into increased
supplies. In the case o agriculture, the disproportion between supply and demand wasmore moderate, though the growing demand or biouels operated as a major mechanism
o transmission o high energy prices into higher agricultural prices, particularly during the
second semester o 2007 and the rst semester o 2008 - the last phase o the commodity
price boom.6
Additional actors afecting commodity prices during the latest phase o the boom
were dollar exchange rate volatility and nancial speculation. These actors resulted in an
unprecedented level o price volatility. The turnaround o price trends took place since July
or most commodities and since August or energy products and thereore preceded the
nancial collapse o mid-September. But the worldwide credit reeze that ollowed led toa ree all or most commodities. Energy products and metals, which had experienced the
6See, on the latter, von Braun (2007).
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most impressive price boom, were also hit more severely.
Prospects or commodity prices remain poor. They are already below (and, in some
cases, including oil, well below) the most recent projections released by the World Bank,
which orecasted a 25% reduction in energy prices in 2009 and 23% all in non-energy
commodity prices (World Bank, 2009, Table 1.4). The act that many oil exporting countries
and some metal exporters have stabilization unds in place will serve as an importantcushion. For agricultural exporters, such a cushion does not generally exist.
Falling energy prices bring a major benet or a signicant number o energy importing
developing countries. Indeed, one reason behind the large number o developing countries
with growing current account decits had been the efect o high energy prices. So, alling
energy prices will afect energy exporting countries but benet a relatively large number o
energy importing developing countries.
Falling prices will be reected in reduced investment and economic activity in
commodity-dependent developing countries, the number o which is still relatively large,
particularly in Arica, the Middle East, North Arica, and Latin America. Indeed, low commodity
prices will be the major mechanism o transmission o the world crises to poor countries. For
these countries, a major opportunity ahead is to redesign their trade strategy to reduce their
commodity dependence.
Policy ResponsesIII.
National responsesA.
Given the act that there has been a worldwide trend towards external opening in recent
decades, the ongoing crisis will have severe efects on developing countries. As indicated,
remittances will show some resilience. Financial turmoil will have stronger efects on middle
income countries more integrated into world nancial markets, whereas low-income
countries dependent on ocial ows will remain less afected by the capital ows channel.
Given the magnitude o the collapse o commodity prices, the trade channel will afect all
countries, but is likely to afect commodity-dependent economies more, many o which are
low income countries. Countries with stabilization unds (generally, energy exporters and
some metal exporters) will be able to use past savings to cushion the efect o commodityprice downswings.
National responses should aim to mitigate the contractionary efects coming rom
abroad and to rethink their trade strategies. The room or maneuver to adopt expansionary
scal and monetary policies will depend on balance o payments constraints. In the case
o scal policy, it also depends on recent scal stances, inherited public sector debts and
the existence (or the absence) o well-developed domestic bond markets where the public
sector can nance its current imbalances in non-inationary ways. Given the dependence on
balance o payments constraints, the availability o external nancing will be critical.
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The enclosed table summarizes the evolution o three major external variables during
the recent boom - the current account balance, external debt and oreign exchange reserves
- in 90 developing and transition economies7, each with a population o over 5 million as
o 2007. The table shows the simple averages o ratios o these variables to GDP or each
region, as well as the proportion o countries showing improvement in the indicator over
the boom.
External Indicators o Developing and Transition Economies with Population Over 5 Million
Numbero
countries
Current Account Balance External DebtForeign Exchange Reserves,
excl. gold
% o
GDP2003
% o
GDP2007
% with
decit,2007
% with
improve-ment
% o
GDP2003
% o
GDP2006
% with
improve-ment
% o
GDP2003
% o
GDP2007
% with
improve-ment
Arica 31 -5.6 -4.2 87% 45% 89.7 43.0 97% 12.8 18.1 78%
Central andEasternEurope
8 -5.4 -9.1 100% 38% 56.4 57.3 57% 21.0 23.2 63%
CIS 8 -1.0 3.1 63% 25% 56.1 44.5 88% 12.9 21.3 100%
Latin Americaand theCaribbean
16 -0.7 -0.9 50% 38% 63.7 37.6 100% 11.7 14.8 69%
Middle Eastincl.Egypt
7 7.2 6.5 43% 43% 54.0 28.6 100% 41.1 50.1 40%
Asia, incl. NICs 20 2.2 3.0 30% 45% 52.6 36.9 100% 27.2 32.7 69%
Total 90 63% 41% 94% 72%
Source: Own estimates based on IMF, International Financial Statistics
The dominant pattern over this period was an increasing number o countries with
current account (and indeed larger size) decits. This trend was matched, however, by broad-
based and, in many cases, large improvements in debt ratios and, to a lesser extent, by oreign
exchange reserve accumulation. Debt improvements were associated both with domestic
policies and with the major debt relie initiatives or low-income countries (the Multilateral
Debt Relie Initiative and a major debt relie granted individually by the Paris Club). Foreign
exchange reserve accumulation underestimates the magnitude o the improvement, as it
does not include scal unds held abroad by either sovereign wealth or stabilization unds.
In regional terms, the Middle East, Asia and the CIS show the best perormance in the
three dimensions (less so in the case o debt in the CIS). Arica shows large current account
decits but signicant improvements in the two other dimensions. Latin America and the
Caribbean stands out or its avoidance o current account decits and large improvements
in debt ratios. Central and Eastern Europe shows the weakest stance: large current account
decits with limited or no improvements in debt and oreign exchange reserves.
Unortunately, no equivalent picture can be drawn or scal indicators. However, or
those countries or which data are available, weak scal positions are generally inrequent.
7Comparable inormation is available or the 90 countries in the case o the current account, or 80 in the case o
external debt and 78 or oreign exchange reserves.
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Again, Central and Eastern Europe and major South Asian countries stand out as having the
weakest positions, but there are individual countries with large central government decits
mixed with high levels o public sector debt in other regions as well, such as Colombia and
El Salvador in Latin America, and Egypt and Jordan in the Middle East.
The picture, thereore, is one in which developing countries do have larger room or
maneuver to adopt counter-cyclical policies than in the past. The major regional exceptionis Central and Eastern Europe, where the traditional mix prevails o weak external and scal
indicators that has led to requent macroeconomic crises. That mix is inrequent elsewhere,
though there are two notable cases in South Asia (Pakistan and Sri Lanka). These countries
will have to undergo some traditional macroeconomic adjustment. It is essential, however,
that in these cases the scal adjustment is done in such a way as to avoid the worst o pro-
cyclical scal adjustments o the past, and is able in particular to maintain good levels o
public sector spending in the social sector and in inrastructure. In the past, scal reorm
packages that ocus on strengthening government revenues have shown to be preerable
to sharp spending reduction packages.
The nature o the policy packages to be adopted depends on the countries current
stance. For those countries with a strong debt and oreign exchange reserve position but
relatively weak scal stance (India and Colombia are two important examples), the room
or maneuver lies more in monetary than with scal policy. More generally, most emerging
economies have the capacity to avoid the traditional pro-cyclical monetary policies o past
crises and ollow the expansionary policy trajectories o industrial economies. Most have
actually adopted policies to ease domestic nancing, to acilitate access o private sector
companies to oreign exchange and, to a lesser extent, to reduce domestic interest rates.
They should continue to move in that direction. A similar rule o easing monetary policy
should be ollowed by other developing countries.
In the scal area, there is signicant room to maneuver in a relatively large group o
developing countries. They should use this space to mitigate the efects o the external
shock. Inrastructure investment and social spending should be the ocus o these programs.
The strategy will depend on each countrys social policy ramework. Universal social policies
in the areas o nutrition, basic education and health should be the major policy ocus, but
targeted programs or the poor, such as conditional cash transers, make sense in middle-
income countries (in poorer countries, by denition, poverty is widespread and universal
programs are clearly superior). Special emergency employment programs should be theessential complement, since unemployment insurance, the traditional automatic stabilizer
o industrial countries is generally absent in developing countries. Within the available mix
o policies, experience indicates that tax reduction policies are unlikely to have the best
efects and, rather, strengthening the tax base should be the ocus o policy makers.
Although trade opportunities are not generally viable, trade policy can play a
role in the recovery in at least three diferent ways. First, non-traditional exports can be
encouraged, particularly in commodity-dependent economies, through a mix o exchange
rate depreciation and sectoral incentives. Second, the possibility o strengthening domestic
linkages o existing manuacturing export activities can also play a role. Third, more activeSouth-South cooperation can play a role, by encouraging trade through existing integration
processes. Payments agreements among central banks can also play a role in acilitating
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such trade without the need or hard currencies.
Finally, and very importantly, the crisis provides an opportunity to rethink the role o
domestic markets, which were largely let out rom the radar o policy makers during the
reorm period. Indeed, a major implication o expansionary macroeconomic policies is that
all countries can contribute to the global economic recovery by ocusing on their domestic
demand. Protection policies would be clearly counter-productive, generating beggar-thy-neighbor efects. But policies that ocus on the mass market or consumer goods and on
strengthening small- and medium-sized enterprises, which tend to depend heavily on local
markets, can play a role in policy packages that place domestic demand again at the center
o economic policy.
Global responsesB.
Given all the channels through which nancial contagion spreads across the world, the
present nancial crisis has shown again how dysunctional the current international
nancial architecture is. Whereas previous crises have demonstrated the deciencies o this
architecture or managing the nancial vulnerability o developing countries, the currentcrisis has made patently clear the major nancial regulatory decit that characterizes the
global system. Unortunately, although deep aws were identied during previous crises in
developing country there was little progress on any signicant reorm o the international
nancial architecture (Grith-Jones and Ocampo, 2003). The act that this time the crisis
started in developed countries provides a hope or action though also the risk that action
would ocus on industrial rather than developing countries. Within the G-20, the call by
several countries to engage in a serious reorm and the prospects o the Commission o
Experts o Reorms o the International Monetary and Financial System convened by the
President o the UNGA are most commendable.
Correcting the regulatory defcit o global fnance1.
The magnitude o the current crisis is clearly associated with inadequate regulation and
supervision o banks and nancial markets. Since the Asian crisis, it became widely accepted
that nancial liberalization must be accompanied by stronger prudential regulation and
supervision. This lesson was applied in many parts o the developing world but, paradoxically,
was largely ignored in the United States and the United Kingdom, where liberalization was
accompanied by deregulation and weak supervision o nancial intermediation (Stiglitz,
2008).
The new regulatory governance should be based on a well-unctioning network o
national and regional authorities and include truly international supervision o nancial
institutions with a global reach.
First o all, the institutional structure that responds to this challenge should have
adequate representation rom developing countries. This arrangement will ensure not
just greater legitimacy, but also greater eciency, given the growing role o developing
countries in the global economy. Secondly, it should have real power to inuence decisions o
national regulators, especially in the largest countries, including industrial countries. Thirdly,it should take macro-prudential concerns clearly into account. Finally, it should consider
the potential costs o nancial instability on the real economy. For this purpose, it could
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include representation not just rom diferent nancial regulatory bodies across sectors
and countries, but also rom those concerned with growth and equity. For that reason, the
United Nations should have a place in the new institutional structure.
The current deep crisis and numerous previous ones that hit developing countries
seem to demonstrate that crises are inevitable in deregulated nancial systems. There
is, thereore, ever-growing consensus that more complete and more efective nancialregulation is required. Its main objective must be to help avoid uture build-up o systemic
risk.
There are two broad principles on which uture nancial regulation needs to be built
(DArista and Grith-Jones, 2008). The rst is counter-cyclicality, in order to correct the main
market ailure o banking and nancial markets - their boom-bust nature. The key idea is
that provisions and/or capital required should increase as risks are incurred, that is, when
loans are disbursed. In this way, provisions and capital requirements should increase during
periods o rapid credit growth and decrease when lending expands at slower rates (Ocampo,
2003). This would strengthen banks in boom times and discourage them then rom excessivelending. It would also make it easier or them to continue lending in dicult times.
The second key principle or modern, efective regulation should be comprehensiveness.
Economic theory tells us that or regulation to be efective, the domain o the regulator has
to be the same as the domain o the market to be regulated. There is need or comprehensive
and equivalent transparency, as well as regulation o all nancial activities, instruments, and
actors. Both minimum liquidity and solvency requirements need to be regulated. Indeed, i
banks had stronger liquidity, as in the past, their solvency problems could have been smaller
in the current crisis.
Developing countries need to make sure that new regulatory standards allow enough
exibility, so they can be adapted to their needs and characteristics. Also developing
countries should advocate or regulatory changes in developed countries (e.g., derivatives
markets) to ensure their economies will not be harmed by disruptions caused elsewhere.
IMF Reorm2.
Four essential reorms o the IMF should be part o the reorm agenda (see South Centre,
2008). The rst long-term reorm is the creation o a meaningul and truly global reserve
currency, which could be based on the IMF Special Drawing Rights (SDRs). This currency
would overcome both the inequities but also the instability that are inherent in a global
reserve system based on a national, or a ew national currencies (Ocampo, 2007-8). SDRs can
also be used to provide counter-cyclical ocial liquidity to developing countries.
The second issue is the need to place the IMF at the center o global macroeconomic
policy coordination. This is the only way to give developing countries a voice on the issue.
The third, particularly urgent issue is the need or the IMF to lend during balance o
payments crises rapidly, at sucient scale, and without overburdening borrowers with the
conditionalities o the past, particularly when the sources o the crisis are exogenous, such
as a rapid reversal o capital ows and/or a sharp deterioration in the terms o trade. The
recent approval (October 2008) o a airly large and rapidly-disbursing acility by the IMF
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seems positive. The new Short-Term Liquidity Facility (SLF) is a quick-disbursing nancing
mechanism or countries with strong economic policies, which are yet acing temporary
liquidity issues. To qualiy or a loan under the SLF, countries must have sound macroeconomic
policies and sustainable debt burdens. Additionally, the last annual country assessment by
the IMF must have been positive. The IMF stated that Given this strong emphasis on past
perormance, nancing is made available without standard phasing, perormance criteria,
monitoring, and other conditionality o a Fund arrangement. Countries will be allowed toborrow up to 500% o their quota.
The U.S. Federal Reserve simultaneously announced the establishment o temporary
swap lines with the Central Banks o Brazil, Mexico, Korea, and Singapore.
The IMF SLF plans to keep the results o countries rejected condential, as to not
increase market instability in rejected countries. However there is a concern that the
SLF is essentially dividing developing countries into an A-list o nations that qualiy or
loans without strings, and a B-list o everyone else. As Kemal Dervi, UNDP Administrator
(Washington Post, November 2, 2008) put it: Emerging markets cannot be easily and simplydivided into two categories: those with good and those with bad policies. It would seem ar
better to enlarge access to SLF to a airly large number o countries with reasonably good
policies (Bhatttacharya, Dervi and Ocampo, 2008).
There should also be a major and quick reorm and more active use o compensatory
nancing to reduce the large cost o adjustment or developing countries hit by exogenous
shocks linked to their terms o trade. Compensatory nancing has become urgent, given
the sharp all in commodity prices, with highly negative efects. The IMF Compensatory
Financing Facility has not been used since 2000 due to very tight conditionalities. For low-
income countries, the enhancement o the Poverty Reduction and Growth Facility (PGRF)to compensate or the adverse terms o trade shocks, and the Exogenous Shocks Facility
(compensatory nancing without a PRGF) are clearly insucient, especially as regards the
scale o the lending. An expansion o this acility is urgent, given the severity o the current
crisis and the potential damage it could do to low-income countries growth and poverty
reduction, which could set them back or meeting the MDGs. Especially in the light o recent
sharp alls in commodity prices, the ollowing broad suggestions or compensatory nancing
seem especially relevant (see, or more details, Grith-Jones and Ocampo, 2008):
Scaling up: Perhaps the most important point is that the scale o existing acilitiesi)
and the amount o resources in each acility are too small in proportion to the shocks.This includes resources available or grants and or the subsidies that allow concessional
nancing o loans. There should be ewer restrictions on the scale o acilities (e.g.
higher per cent o resources that can be accessed in relation to IMF quotas).
Both loans and grants are valuable: In the case o low-income countries, grantsii)
are more useul or shocks with more permanent efects, such as natural disasters.
However, ocial lending has an important role to play as it is potentially speedier and
may provide incentives or changes in the economy to reduce its vulnerability.
IMF lending or trade shocks needs ar-reaching changes: There should be signicantiii)simplication o IMF acilities as they are too many (e.g. enhanced PRGF, ESF and others)
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and too complex. Indeed, an option to consider may be to merge all these IMF trade
compensatory nancing acilities or low-income countries into one low-conditional
acility at the IMF.
Less conditionality is clearly needed. For countries with reasonable policies there isiv)
no justication or tight credit conditionality especially when imbalances result rom
external shocks.Coordination o global macroeconomic policy or growth and poverty3.
reduction
The global recession now under way calls or a coordinated policy response. It means
expansionary monetary, credit and scal policies in all industrial countries. Many are now
adopting such policies. Developing countries should also be part o the solution, and should
adopt equally expansionary policies, individually and in a coordinated way. As we have
pointed out above, countries that have accumulated large amounts o oreign exchange
reserves and have limited external debt ratios do have a larger room or maneuver to adopt
these policies, compared with previous crises. For those who do not have this policy space, it
is essential to avoid the IMF conditionalities o the past, which orced developing countries to
adopt contractionary macroeconomic policies. It is important to make available suciently
large-scale and rapidly disbursing IMF acilities.
Some large developing countries can actually have a strong inuence on world economic
activity. Given its size, large reserves and strong scal position, China plays a particularly
crucial role in this regard. China needs to boost its domestic demand signicantly, along the
lines announced in late 2008,8 and increase nancial support to other developing countries,
which will benet both China and the world economy.A large increase in ocial development assistance to low income countries can play an
important role or both combating poverty and contributing to the generation o aggregate
demand at the global level. Additional ODA and highly concessional lending with low
conditionality (e.g., rom World Banks IDA) is particularly important to avoid contractionary
policies in the poor countries sufering a deterioration o their terms o trade due to the
collapse o commodity prices or other external shocks. This will signicantly help poor
countries to avoid setbacks in their aim to meet MDGs.
Past crises have also shown that multilateral development banks can play an essential
role as lenders when private nancing dries up. One particularly problematic issue during
crises in developing countries is the curtailment o commercial credit available to exporters,
limiting an essential mechanism through which countries can recover rom crises. So,
the launching by multilateral and/or regional development banks o a large program o
commercial lending and/or guarantees should be at the center o the crisis response eforts.
No conditionalities should be attached. To substitute or the sharp reduction in private ows,
these banks should expand lending rapidly. Unortunately, as pointed out in our diagnosis,
the scale o ocial lending is small relative to the magnitude o contraction o private ows.
Scaling up the size o MDBs may, thereore, become essential i the credit reeze persists.
8The In November 2008 China announced a fscal stimulus package in the amount o 585 billion U.S. dollars to
be spent over the next two years to fnance programs low-income housing, rural inrastructure, water, electricity,
transportation, the environment, and technological innovation among other priority areas. (Note rom the editor)
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Regional responses unded by developing countriesC.
In all o the areas o reorm, the IMF should collaborate more closely with regional institutions,
such as the Chiang Mai Initiative or the Latin American Reserve Fund.
Developing countries are in an excellent position to contribute to this task, given their
large oreign exchange reserves and their ability to use those reserves more actively. In
mid-2008, developing countries as a whole had a level o reserves approaching $5 trillion.Additionally, many developing countries have created sovereign wealth unds, which have
an additional level o assets o more than $3 trillion. Swap arrangements among central
banks, pooling them in reserve unds or to support the development o regional bond
markets, are mechanisms to multiply the room to maneuver that they provide. These
reserves and existing sovereign wealth unds could also be used to increase the role o
regional development banks owned by developing countries, by investing in the capital o
existing institutions and creating new ones.
Multilateral development banks should maintain their central unction in the
international development architecture and, in particular, in nancing human development,inrastructure and clean energy investment. But regional and sub-regional nancial
institutions owned by developing countries should play an important complementary role,
as they give a greater voice and sense o ownership to developing countries. Moreover,
regional and sub-regional development banks are particularly suited to provide regional
public goods.
I developing countries allocate 1% o their oreign exchange reserves to the paid-
in capital o regional and sub-regional institutions, this would amount to $50 billion at
current levels o reserves. Assuming a ratio o loans-to-capital o 2.4 times9 the expanded
regional and sub-regional development banks could generate additional annual lending
o approximately $120 billion. This additional lending could be very valuable in the current
context.
By expanding or creating new regional and sub-regional nancial institutions,
developing countries could lay the basis or their own current and uture lending capacity,
which would eventually help them meet their development goals. Given their large oreign-
exchange reserves, we believe the time to begin such an initiative is now. A network o
regional development banks is already in place, though unevenly developed in diferent
regions o the developing world. The multiplication and growth o these institutions ishighly desirable.
9This estimate is based on the ratio o the successul and fnancially sound Andean Development Corporation.
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Bhatttacharya, Amar, Kemal Dervis and Jos Antonio Ocampo (2008), Responding to the Financial Crisis:
An Agenda or Global Action, Prepared or the Global Financial Crisis Meeting organized by the Friedrich
Ebert Foundation and the Initiative or Policy Dialogue o Columbia University, November 13. Available at
www.policydialogue.com
DArista, Jane and Stephany Grith-Jones (2008) Agenda and Criteria or Financial Regulatory Reorm,
Prepared or the Global Financial Crisis Meeting organized by Friedrich Ebert Foundation and the Initiative
or Policy Dialogue o, Columbia University, November 13. Available at www.policydialogue.com
Frankel, Jerey (2008) The Unwinding o Carry Trade Has Finally Hit Currencies. http://belercenter.ksg.
harvard.edu/analysis/rankel/?p=32. Accessed February 14, 2009
Grith-Jones, Stephany and Randall Dodd (2008) Derivative Markets, Hedging and Central Bank
Regulation, Working Paper 24, Series Financiamiento del Desarrollo, Santiago, ECLAC. Also available on
www.stephanygj.net
Grith-Jones, Stephany and Jos Antonio Ocampo (2003), What Progress on International Financial
Reorm? Why So Limited?, Stockholm: Expert Group on Development Issues (EGDI) Swedish Ministry or
Foreign Aairs, Almqvist & Wiksell International.
Grith-Jones, Stephany and Jos Antonio Ocampo (2008), Compensatory Financing or Shocks: What
Changes are Needed?, Paper Prepared or the United Nations Committee on Development Policy, April.
Ocampo, Jos Antonio (2003), Capital Account and Counter-Cyclical Prudential Regulations in Developing
Countries, in Ricardo French-Davis and Stephany Grith-Jones (eds.), From Capital Surges to Drought:
Seeking Stability or Emerging Markets, London: Palgrave/Macmillan and WIDER.
Ocampo, Jos Antonio (2007-8), The Instability and Inequities o the Global Reserve System, International
Journal o Political Economy, Nol. 36, No. 4, Winter.
Ocampo, Jos Antonio and Mariangela Parra (2008), This is a boom o mineral, not agricultural prices,
RGE Monitor, May.
Ratha, Dilip, Sanket Mohapatra and Zhimei Xu, Outlook or Remittance Flows 2008-2010: Growth expected
to moderate signicantly, but fows to remain resilient, Migration and Development Brie No. 8, World Bank,
November 11, 2008.
South Centre (2008), South Centre calls or Revamping the Global Financial Architecture, www.southcentre.
org, October 29.
Stiglitz, Joseph E. (2008), Testimony beore the House Committee on Financial Services, October 21. Also
available www.policydialogue.com
UNCTAD (2008), Foreign Investment Report, Geneva
United Nations (2009), World Economic Situation and Prospects 2009, New York, January.
von Braun, Joachim (2007), The World Food Situation: New Driving Forces and Required Actions, Food
Policy Report, Washington, D.C., International Food Policy Research Institute, December.
World Bank (2009), Global Economic Prospects 2009: Commodities at the Crossroads, Washington D.C.
Reerences
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For urther inormation contact:
United Nations Development Programme
Bureau or Development Policy
Poverty Group
304 East 45th Street
New York, NY, 11375
U.S.A.
www.undp.org/poverty
E-mail: [email protected]
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