Trade Negotiations Insights • Volume 7 • Number 9 • November 2008

The global financial crisis: what does it mean for developing countries?

by Tristan Hanson (1)

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It may have started with US sub-prime mortgages, but the current financial crisis is now very much global. Its ramifications – economic, political and ideological – may persist for years to come. Unlike other financial crises of recent decades, this one did not originate in emerging or developing countries; nevertheless, its effects will be felt there too with likely negative consequences for growth and poverty reduction. Economic and financial integration is greater than at any stage for over a century and the forces of globalisation, beneficial in good times, are a source of risk at present. One alarming statistic makes this clear: foreign bank claims on developing countries have almost tripled to $3.1 trillion in just the last five years. (2)

The crisis is transmitted from developed to developing countries via two channels. First, slowing OECD growth means less demand for imports, a headwind to developing country growth rates that may be exacerbated by a consequential spending slowdown domestically. (3) Second, as risk appetite diminishes and financial institutions deleverage, capital flows to developing countries dry up (or reverse), reducing credit availability and increasing borrowing rates. This second channel is already in full force. Emerging market borrowing costs are up sharply since August to their highest level in over five years compared to US treasuries. (4) The MSCI Emerging Markets equity index has lost 53% from its high last year. Developing country and emerging market currencies have weakened significantly against the US dollar since July. (5)

Fortunately, at an aggregate level the structural macroeconomic characteristics of emerging and developing countries are greatly improved from a decade ago: many countries have sustained current account surpluses, accumulating vast international reserves in the process. Such countries are better placed to weather the storm. But in the short-term, even countries that have stockpiled reserves may suffer if their financial sector has borrowed heavily in international markets, as Russia and Kazakhstan’s recent predicaments illustrate.

Aggregation, however, masks weaknesses in a number of countries. Characteristics of countries facing the greatest risk include: a large external debt position, significant gross inflows of private capital or bank credit during the boom years (especially if short-term or in foreign currency), a trend of large current account deficits, rapid domestic credit growth and low foreign-exchange reserves. From this perspective, Eastern Europe and Central Asia appear most at risk. Of the estimated $280 billion increase in gross cross-border bank lending to developing countries from 2003-2007, almost two-thirds went to these regions. Other countries too have attracted big short-term capital inflows in recent years, most notably India, Brazil and Mexico.

The IMF’s recently reduced 2009 growth forecasts of 3% and 6.1% for the world and developing countries respectively, still suggests healthy growth - but the risks must be to the downside. Middle-income countries that borrowed with ease during the boom may suffer most from the fallout in credit markets. Indeed, the IMF forecasts that Eastern Europe, Asia and Latin America will slow appreciably in 2008-09, with African growth only modestly affected.

Nonetheless, low-income countries face material economic risks: slower global growth, reduced foreign aid assistance and declining remittances. For these countries, the direction of commodity prices - and therefore Chinese growth - may hold greater significance than direct financial market aftershocks from the US or Europe. Recent measures in China to stimulate growth are therefore encouraging for commodity exporters and global growth generally, although potentially negative for some commodity importers. The ability of policymakers to support domestic demand will partly determine how individual countries fare in a global slowdown. Those countries with low inflation rates and prudent fiscal policies are best placed in this regard.

For the US and Europe this is the most serious financial crisis since the Great Depression; that is not so for many developing countries which have faced worse before now. Despite the gloom, for the latter a brief period of slower economic growth remains a plausible best case scenario. Moreover, receding inflationary pressure is a positive development. The longer the financial crisis persists, however, the greater the risk of a deeper global recession. Such an outcome would have far more serious implications for all developing economies and might possibly threaten political and social stability in the most fragile of them. All eyes – in developed and developing countries alike – are on the world’s most powerful policymakers. May they find a swift and effective solution.

1 Tristan Hanson is an economist based in London, UK. He holds a Masters in Public Administration in International Development from Harvard University and was formerly an economist for JP Morgan Cazenove.
2 Source: World Bank’s Global Development Finance Report, June 2008. The figure includes cross-border bank lending and foreign-owned branches and subsidiaries based in developing countries.
3 Organisation for Economic Co-operation and Development (OECD) consisting mainly of the world’s richest nations.
4 The JP Morgan EMBI emerging market bond spread is up 250 basis points since August to 573 basis points over US treasuries.
5 The South Korean Won, Brazilian Real, Chilean Peso and Hungarian Forint have each lost more than 25% in the past six months and a number of countries have sold dollars to stem the tide of recent currency weakness.