Usually Much More Regressive Than Food Subsidies

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G

LOBAL

F

INANCIAL

C

RISIS AND

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MPLICATIONS FOR

D

EVELOPING

C

OUNTRIES

G-20 Finance Ministers’ MeetingSão Paulo, BrazilNovember 8, 2008

G

LOBAL

F

INANCIAL

C

RISIS AND THE

C

HALLENGES FOR

D

EVELOPING

C

OUNTRIES

Introduction

The current financial crisis has evolved differently from other major crises that have hit thedeveloping world in recent decades.

Not only is it occurring in a world of unprecedentedfinancial globalization, where the financial sector plays a historically large role in economic activity,but it is also an “imported” crisis, with origins outside the developing world. The crisis also comeson the heels of a major global shock from high food and fuel prices that has imposed a heavy economic burden on many countries and significantly increased the incidence of poverty and vulnerability.

The uniqueness of the current configuration of economic challenges has importantimplications for the nature and effectiveness of the policy options available to developingcountry governments

. It implies that the policy responses of individual developing countries areunlikely to measurably affect the depth and length of the global crisis. However, their actions canaffect the impact of the crisis on their own economies. Policymakers need to be ready to reactforcibly and quickly at the first signs of domestic weakness, including the rapid involvement of external assistance as necessary. More generally, countries need to maintain sound macroeconomicand financial-sector policies, while focusing on mitigating the potential negative impacts of the crisison those living at the margin. The unprecedented scope of the crisis calls for innovative solutions tocomplement those more traditional policies that have a sound record of success under similarcircumstances.

Many developing countries are moving into a new danger zone, with heightened risk toexports, investment, credit, banking systems, budgets, the balance of payments, and themost vulnerable.

With this latest financial crisis, growth is slowing and is likely to weaken evenmore sharply. Developing country exports to developed countries are falling, capital is being withdrawn from emerging markets and short-term credit is drying up. This could trigger a fall inproduction and investment by the productive sector. Sharply tighter credit conditions and weakergrowth are likely to cut into government revenues and governments’ ability to invest to meeteducation, health and gender goals. Countries dependent on exports, remittances or foreigninvestment, exhibiting high current account deficits or rising inflation, and those with extensivefuel/food subsidies are most vulnerable to a sharp slowdown—especially if accompanied by asignificant tightening of financial market conditions. Coming on the heels of the food and fuel priceshock, the global financial crisis could significantly set back the fight against poverty.

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Economic Context

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The global financial crisis that emerged in September 2008, following more than a year of financial turmoil, will have serious implications around the globe.

Developing countries wereat first sheltered from the worst elements of the turmoil, but this is no longer the case, as thecyclical downturn that was already under way in September has intensified. Financial conditions havebecome much tighter, capital flows to developing countries have dried up, and huge amounts of

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The World Bank estimates that a one percentage point reduction in growth could trap 20 million more people into poverty.

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The discussion of the global outlook draws on the forthcoming

Global Economic Prospects: Commodities at theCrossroads

which will be released by the World Bank on December 9, 2008.

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capital have been withdrawn, leading to sharp falls in equity valuations and increases in bondspreads. As of mid-October, developing country equity markets had given up almost all of theirgains since the beginning of 2008 and initial public offerings had disappeared. Spreads on sovereignbonds and commercial debt (which until recently had been the most important source of developing-country finance) have risen sharply. Bank lending is also down and foreign directinvestment inflows are expected to decline in the final quarter of the year.

Virtually no country, developing or industrial, has escaped the impact of the wideningcrisis

, although those countries with stronger fundamentals and less integration into the globaleconomy going into the crisis have generally been less affected. The deterioration in financing conditions has been most severe for countries with large current account deficits, and for those thatshowed signs of overheating and unsustainably rapid credit growth prior to the intensification of thefinancial crisis. Of the 20 developing countries whose economies have reacted most sharply to thedeterioration in conditions (as measured by exchange rate depreciation, increase in spreads, equity market declines and large current account deficits), seven come from Europe and Central Asia, andeight from Latin America. And as a knock-on effect, with the crisis taking its toll on even the most well off countries, there is a serious risk that some donors might consider stepping back from aidcommitments when they are most needed.

Consensus growth projections for developed countries in 2009 are being slashed and worldtrade volumes may fall for the first time since the 1982 recession

. The consequent downturn indeveloping country exports will be the most widespread shock generated by the crisis and privatecapital flows to developing countries are likely to fall significantly in 2009, led by pull-backs inportfolio flows and international bank lending. On the positive side, improvements inmacroeconomic policies in developing countries over the past decade (e.g., more sustainable fiscalpolicies, build-up of large foreign exchange reserves) especially in large countries, suggest thatunsustainable levels of sovereign debt are likely to be less of an issue in the initial stages than inprevious crises. But if fiscal positions deteriorate under the impact of the crisis, sovereign debtburdens may increase rapidly, and access to international capital markets may become more of aconstraint.

Earlier concerns about rapid credit growth in some developing countries have been proven valid.

Large portfolio and foreign bank lending flows have contributed to rapid growth in credit tothe private sector and large private-sector driven current account deficits in a number of countries. The sudden deceleration of inflows will force a sharp adjustment in private-sector activity. There isa high probability of balance sheet deterioration and possible banking crises where banks and non-bank financial institutions have expanded credit to the private sector most rapidly. There may be anespecially direct channel in economies where there has been substantial borrowing from foreignbanks, either through branches in the domestic market or through borrowing by local banks.Central and Eastern European economies, which have experienced especially rapid credit increases, with foreign banks playing a dominant role in the domestic market, could be most at risk.

Investment is expected to suffer as it bears much of the direct impact of the financial crisis.

Investment was the main driving force for developing-country growth over the past 5 years,contributing almost half of the increase in domestic demand. For 2008, investment is expected toincrease only moderately in middle-income countries, compared with 13 percent growth in 2007. There is a risk that investment in developing countries may be headed for a “perfect storm,” with aconvergence of slowing world growth, withdrawal of equity and term lending from the private

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