Hausmann on the global financial crisis

Hausmann has a nice piece on the VoxEu website about the global financial crisis and how global and regional multilateral institutions can help the developing countries cope with the fallout of this crisis on their economy (basically, by stepping up lending and widening their scope and role). He uses the fan belt analogy (I think this one is his favorite as he uses this one in the growth diagnostics studies as well)!

When the fan belt of the car breaks, the engine overheats, seizes, and stops. A new fan belt is no longer enough for a solution. If the Wall Street is the belt, Main Street is the engine. Since the engine has seized, even fully capitalised banks will be weary to lend into a downturn, and firms and households would be unwise to borrow, even if credit was available. Credit crunches often lead to recessions, but the eventual recovery has never been lead by credit, as Calvo, Izquierdo and Talvi (2006) have shown for emerging markets.

A more sustainable complementary alternative is to use the super-borrower capacity to reflate the global economy and to reestablish financial links globally. This can be done in several ways.

First, multilateral development banks should be recapitalised –by issuing guarantees in the form of callable capital – allowing them to raise funds in global capital markets to on-lend to the developing world.

Second, the IMF should also be recapitalised, possibly through an issuance of SDRs, so as to make sure that the organisation has more than enough funds to help reconnect countries to finance.

See my earlier discussion about the fallout of the global financial crisis on the developing countries here.

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.

Green jobs and pro-poor policy

UN secretary-general Ban Ki-moon and Nobel laureate and former US vice-president Al Gore argue for ‘green growth’ and pro-poor policies:

What we need is both stimulus and long-term investments that accomplish two objectives simultaneously with one global economic policy response – a policy that addresses our urgent and immediate economic and social needs and that launches a new green global economy. In short, we need to make “growing green” our mantra.

First, a synchronised global recession requires a synchronised global res­ponse. We need stimulus and intense co-ordination of economic policy among all main economies.

Second, we need “pro-poor” policies now. In much of the developing world, governments do not have the option to borrow or print money to cushion the devastating economic blows. Therefore, governments in industrialised countries must reach beyond their borders and invest immediately in those cost-effective programmes that boost the productivity of the poorest. Last year, food riots and unrest swept more than 30 countries. Ominously, this was even before September’s financial implosion, which sparked the global recession that has driven a further 100m people deeper into poverty.

This means increasing overseas development assistance this year. It means strengthening social safety nets. It means investing in agriculture in developing countries by getting seeds, tools, sustainable agricultural practices and credit to smallholder farmers so they can produce more food and get it to local and regional markets. Pro-poor policy also means inc­reasing investments in better land use, water conservation and drought-resistant crops to help farmers adapt to a changing climate, which – if not add­ressed – could usher in chronic hunger and malnutrition across large swaths of the developing world.

The effect of global economic crisis on poverty

The World Bank estimates that as many as 53 million additional people could fall below the poverty line of $1.25 a day due to the impact of global economic crisis. Declining growth rates coupled with high levels of poverty would be a disaster in the developing countries. It argues that almost 40% of developing countries are exposed to the declining growth rates and high levels of poverty, and an additional 56% of the countries are exposed to decelerating growth or high poverty levels. Less than 10% of the developing countries face ‘little risk’.

It also paints a gloomy picture about infant mortality. It states that between between 200,000 and 400,000 more babies could die each year between now and 2015 if the crisis persists (this totals to 1.4 to 2.8 million).

What about the capacity of the developing countries to deal with the crisis on their own? A WB policy brief states that one-fourth of the countries have the ability to expand fiscal deficits to undertake significant countercyclical spending. Even one-third of these require aid to take this course of action. All others vulnerable countries are fiscally unable to tackle this problem on their own. The bad news is that only one-third of the countries have the institutional capacity to absorb increased spending even if there were external assistance.

Last week, the IDS complied views and analysis from wide range of experts from the developing countries on the fallout of global financial crisis on the developing countries. They identified six main ways the financial crisis will affect the developing countries: lower demand for exports, fall in portfolio and foreign direct investment, fall in exchange rate, rising risk premiums and interest rates, decline in remittances, and decline in foreign aid. On top of this, last year’s rise in commodity and food prices is expected to push over a 150 million people below the standard dollar a day poverty line. More on the impact of food prices here.

Taxes, revenues and expenditures in South Asia

This is how tax structure, revenues and expenditure looks like in South Asia.

Country	VAT (%)	Corporate income tax (%)	Total tax rate (% of profit)
Maldives	0	0	9.1
Pakistan	15	35	28.9
Nepal	13	20	34.1
Afghanistan	--	20	36.4
Bangladesh	15	40	39.5
Bhutan	--	30	39.8
Sri Lanka	15	35	63.7
India	12.5	30	71.5

Source: Doing Business Report 2009

Nepal’s tax rates are the third lowest in the SAARC region. My main point: appropriability concerns due to taxes are not a binding constraint on growth in Nepal. For my bet on infrastructure see this.

Meanwhile, this is what the revenues and expenditures (% of GDP) looks like in South Asia:

And, this is how fiscal balance looks like:

Source: ADB

The puzzle now is: despite having one of the lowest and simplest tax rates, why revenue is always low in Nepal? Tax evasion and inefficient bureaucracy to check evasion might answer a part of the question. I am still looking for the other part!

Lower taxes always does not mean higher revenue (supply-side econ???). Moreover, higher taxes also does not necessarily mean higher revenue. What comes into play? Other stuffs that affect revenue collection such as bureaucratic efficiency, corruption, level of tax evasion, depth of informal economy… What would be a good policy if first best policy options do not deliver intended outcomes? Well, second best policy options might help before going for first best policy options. This takes me to Lipsey and Lancaster’s 1956 paper and Rodrik and Hausmann’s growth diagnostics!

The other side of the crisis

Friedman writes in the NYT:

…the U.S. Senate unfortunately voted on Feb. 6 to restrict banks and other financial institutions that receive taxpayer bailout money from hiring high-skilled immigrants on temporary work permits known as H-1B visas.

It is a lose-lose strategy! It reminds me of a Sanskrit proverb: Bad times, bad decision!

Friedman has a solution:

When the best brains in the world are on sale, you don’t shut them out. You open your doors wider. We need to attack this financial crisis with green cards not just greenbacks, and with start-ups not just bailouts.

Note this as well:

…more than half of Silicon Valley start-ups were founded by immigrants over the last decade. These immigrant-founded tech companies employed 450,000 workers and had sales of $52 billion in 2005

Nepal: Poor Infrastructure, Poor GDP Growth Rate!

This is how Nepal stands in infrastructure rating in the world: out of 134 countries considered in Global Competitiveness Report 2008-2009, Nepal ranks 132. Deficient supply of infrastructure and poor quality of existing ones are the recipes for industrial retardation and slow economic growth rate. The figure below shows infrastructure rating of Asian and Sub-Saharan African nations plotted against GDP per capita of 2006 in constant 2000 US$.

I guess it is not surprising that Nepal is the poorest country in Asia (and twelfth poorest nation in the world) and has the one of the poorest infrastructure ratings (quality and quantity) in the world. The transportation costs (inland + international) is also the highest in South Asia. The transportation costs for textile and clothing industry is the highest in the region and is three times the cost prevailing in India.

Some people argue that this is expected because Nepal is a landlocked country. Well, there is no reason to believe that a landlocked country must be in short supply of good quality infrastructure (roads, rails, ICT, and airways). I wonder why Burkina Faso, a landlocked country in Sub-Saharan Africa, is able to have more road density and better infrastructure rating than Nepal!

My bet: the biggest binding constraint on growth in Nepal is bad infrastructure. This is what I claim in my new paper on growth diagnostics of the Nepali economy. That said, I also show why other constraints do not qualify to be the most binding constraint on growth. Full paper to be finished by the end of this month. More on this stuff coming soon!