Thursday, February 5, 2009

Financial crisis and developing countries

The Globalisation Team at the Institute of Development Economics has a nice compilation of views and analysis on the fallout of global financial crisis on the developing countries. It has interesting perspectives from different countries.

They argue that the cause of the global financial crisis is not just restricted to the US subprime mortgage crisis. In fact, it was a result of the interaction between at least three factors: (i) excessive reserves in surplus countries and huge US fiscal and current account deficits, (ii) expansionary monetary policies in the OECD, and (iii) complex and flawed financial innovation in the developed countries.

Six ways the financial crisis will affect the developing countries:

  • lower demand for exports: In Bangladesh, orders for ready-made garments from Europe and the US dropped 7 per cent in September. In Kenya, the cut flower industry is suffering as European customers are hit by the crisis
  • fall in portfolio and direct foreign investment: Investors shy away from markets that are perceived to be riskier. The Ethiopian Electric Power Corporation has indicated that its investment plans will be severely affected due to the crisis
  • falls in exchange rate: The sudden withdrawal of foreign capital from several developing countries has caused dramatic falls in their exchange rate. Companies and governments with substantial foreign currency denominated debts may contract or even collapse as a result
  • rising risk premiums and interest rates for developing countries on global capital markets
  • decline in remittances from workers in recession affected countries
  • foreign aid decline: Richer countries will reduce aid as governments reassess their fiscal priorities during a downturn. This could have particularly negative consequences for Africa

    It is a great compilation but the policy recommendations are kind of shallow! They propose increase in aid flows, enhancing social protection, and restructuring IFIs. It is incredibly difficult to do all of these at this time, especially when the major donor economies are in distress. I think rather than depending on foreign aid perennially, they should focus on streamlining governance and accountability, ease business restrictions and create a more investor-friendly climate so that domestic entrepreneurs become active in the economy. It does not make sense to prescribe policies that were/are the same  as before and during the financial crisis.

    The dynamics has changed drastically and the developing countries should heed it and flow with it. Though aid is vital for the developing economies to sustain health care, development and education expenses, it should not be seen as an elixir to all the problems.