Wednesday, February 18, 2009

Impact of the financial crisis on the developing world

In a new UNU discussion paper, Wim Naude argues that the financial crisis would affect the developing countries through three different channels. They are (i) banking failures and reductions in domestic lending, (ii) reduction in export earnings, and (iii) reduction in financial flows. It is a nice summary of the causes and impacts of the financial crisis on the developing countries. See this report from the IDS as well. Below is a chart (sourced from Naude’s discussion paper) that summarizes required responses to the financial crisis.

The International Monetary Fund (IMF) expects growth in world trade to decline from 9.4 per cent in 2006 to 2.1 per cent in 2009. The expected declines will come through a combination of lower commodity prices, a reduction in demand for their goods from advanced economies and less tourism. Moreover, the International Labour Organization (ILO) predicts that unemployment could rise by 20 million across the world and that the number of people working for less than the US$2 per day poverty line will rise by 100 million.

There is little doubt that the developing countries would suffer less than the developed world. A large scale fiscal stimulus is beyond the developing countries’ reach because of revenue shortage, fiscal imbalance, and institutional capacity.

The developing countries will not have to worry that much about containment of financial panic in the immediate term because the epicenter of the crisis was in the Wall Street. However, they will have to take on the short term measures as outlined above in the chart. Recapitalizing banks and encouraging merger and acquisition would help consolidate the financial sector. This should be coupled with expansionary monetary policies such as raising inflation targets (but don’t adhere to strict inflation targeting as it binds monetary tools required to respond in these kind of situation) and reducing costs of borrowing (by decreasing lending rates). The fiscal response has to be bigger and bold with an increase in infrastructure spending (it is needed anyway because of severe short supply of infrastructure), expansion of social safety nets (also conditional cash transfers) and spending on education/human resources. On the trade side, the developing countries should lobby for more open markets abroad and also keep their markets open (to be fair to all, there should not be protectionist moves).

The question is: from where the developing countries are going to get the required funding? Well, the developed world has to do something to prop up investment and consumption in the developing countries. The WB proposed 0.7% of the stimulus package to go to Vulnerability Fund for the developing countries. This fund is supposed to increase investment in infrastructure projects, safety net programs, and financing for small and medium-sized business and microfinance institutions. The IMF has to expand SDRs (with minimal conditionality) to all the developing countries, not just a select few emerging ones. See this and this by Rodrik.

See my earlier opinion piece on the impact of global financial crisis on the Nepali economy here. Also see this.

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