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The impact of the global financial crisis on Global North has been much analysed in the media and academic journals, however what about the developing world? The crisis could lead to debilitating macro-economic meltdown for those most in need, says a new report by the Institute for Development Studies.

20th November 08 - Neil McCullock, Institute of Development Studies

Link to report: Voices from the South - the Impact of the Financial Crisis on Developing Countries

'The debate in rich countries about the impact of the global financial crisis has largely ignored its impact on developing countries. But it is vital that policymakers from both North and South understand how this crisis may impact developing countries and the implications for development policy.’ Neil McCulloch, IDS Fellow.

This report presents snapshots of the financial crisis as seen by 21 thinkers, academics and policymakers in 14 developing countries. IDS invited them to present their views on the likely impacts and possible responses to the crisis. Most importantly, results show that developing countries cannot be treated as a homogenous block – concerns vary significantly across countries, depending on their current economic situation, exposure to specific impacts and capacity to respond. Isolation from world financial markets will not protect the poorest countries, as the indirect impacts are likely to be severe.

Impacts

The report identifies six main pathways of impact:

1. Exports. Export growth is already slowing markedly in several developing countries. In Bangladesh, orders for ready-made garments from Europe and the US dropped 7 per cent in September. Year on year exports from the Philippines to the US are down by 15 per cent. In Kenya, the cut flower industry is suffering as European customers are hit by the crisis.

2. Foreign investment. Both portfolio and direct foreign investment have dropped dramatically in several countries as 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.

3. 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. The Rand lost 35 per cent of its value between mid-September and mid-October. The Philippine peso was down 12.3 per cent over the year. The Indian rupee hit a record low to the dollar.

4. Interest rates. As foreign investors withdraw, risk premiums and interest rates have risen for developing countries on global capital markets. Philippine sovereign bond spreads and credit default swap spreads widened as of the end of September, the latter to 283.1 basis points from 265 basis points in June.

5. Remittances. A key concern for some countries (e.g. Philippines, Ethiopia) is the decline in remittances from workers in recession affected rich countries. Orders for Mbuzi ya Jamii (goat for the family) are down sharply at online stores that allow Kenyans abroad to pay for products and services for their families back home.

6. Foreign aid. Many countries expect that aid from rich countries will decline as governments reassess their fiscal priorities during a downturn. This could have particularly negative consequences for Africa. Private foundations are already scaling down their budget allocations, while contributors from Kenya, Ghana and Ethiopia all believe that there will be a decline in official aid.

Developing Policy Responses

Policy responses must take the following points into consideration:

Countries will be affected differently by the pathways listed above. Developing a typography of countries will allow for heterogeneity of responses to address their specific needs.

Within national economies some people will have more exposure to the affects than others.

There are governance implications at international and national levels.

We propose three specific policies that should be pursed:

Increase aid flows.

Enhance social protection.

Restructure International Financial Institutions.

Policy Options

The debate in rich countries about the impact of the global financial crisis has largely ignored its impact on developing countries. But the instability in financial markets around the world is already spilling over to the ‘real economy’ in poorer countries around the world. It is vital that policymakers from both North and South understand how this crisis may impact developing countries and the implications for development policy. This briefing examines the causes of the current financial crisis and how it is already affecting developing countries – based on ‘snapshot’ briefings by key thinkers, academics and policymakers in 14 developing countries. It also examines three key policy implications: the impact on aid, appropriate social protection measures and a fairer financial architecture.

Causes of Crisis

Although much attention has been focussed on the problems in the sub-prime mortgage market in the US as the trigger of the current crisis, it is important to recognise that the origin of the crisis lies in the interaction between at least three factors:

1. The extraordinary accumulation of reserves in surplus countries (notably China and the Middle East) –mirrored by huge US fiscal and current account deficits. In effect, excessive saving in a set of developing countries has funded excessive consumption in the world’s richest economies.

2. The application of expansionary monetary policies in the OECD, giving rise to low interest rates, helped to create the housing market bubble which has now burst.

3. Financial innovation in developed countries, in the form of securitised mortgages, expanded leverage, and poorly regulated derivative instruments, which allowed some major financial institutions to become dangerously exposed. 

While these three factors have played an important role in making the financial system more susceptible to crisis, for many developing countries the seven year period prior to the crisis was one of rapid growth, rising commodity prices, an improved macroeconomic situation and, critically, reduced poverty. The current policy dilemma is how to facilitate a rapid return to this relatively favourable growth pattern, whilst changing global financial governance to minimise susceptibility to crises.

Pathways through which the Crisis affects Developing Countries

The Institute of Development Studies invited key thinkers, academics and policymakers in 19 developing countries to present a brief ‘snapshot’ of the financial crisis from their own country’s viewpoint. Respondents identified seven pathways through which the crisis is affecting developing countries, Table 1 shows how these effects are already being felt throughout the developing world.

Exports: Export growth is already slowing markedly in several developing countries.

Foreign Investment: Both portfolio and direct foreign investment have dropped dramatically in several countries as investors shy away from markets that are perceived to be riskier.

Exchange rate: Sudden withdrawal of foreign capital from several developing countries has caused dramatic falls in their exchange rates. Companies and governments with substantial foreign-currency denominated debts may contract or even collapse as a result.

Higher interest rates: As foreign investors have withdrawn, risk premiums and interest rates have risen for developing countries on global capital markets.

Remittances: A key concern for some countries (e.g. Philippines, Ethiopia) is the decline in remittancesfrom workers in recession-affected rich countries.

Declining aid: Many countries expect that aid from rich countries will decline as governments reassess their priorities. This could have particularly negative consequences for Africa.

Lower growth: Ultimately the crisis will reduce growth in most developing countries endangering the achievement of the Millennium Development Goals.

Impact on Aid: A particular concern is that slower growth and recession in rich countries will slow down or postpone increases in overseas aid. The 2002 Monterrey Consensus on Financing for Development urged developed countries to make ‘concrete efforts towards the target of 0.7 per cent of gross national product (GNP) as ODA to developing countries and 0.15 to 0.20 per cent of GNP of developed countries to least developed countries’.

Since then, several countries have set ‘binding’ timetables to achieve this target. In 2005, at Gleneagles, the EU set targets for its 15 established members: 0.51 per cent of Gross National Income (GNI) in aid by 2010 and 0.7 per cent by 2015 (new member states will aim for 0.17 per cent and 0.33 per cent). A few countries have made more ambitious individual commitments (UK 0.56 per cent in 2010 and 0.7 per cent by 2013). The US and Japan have not set targets. Moreover, the Gleneagles Summit saw the G8 and other donors agree on a comprehensive package to double aid by 2010, with an extra $50 billion worldwide and $25 billion for Africa.

Even before the crisis, donors were not on target for achieving these targets. Now with the large additional fiscal costs of rescuing the banking system and additional expenditures to minimise the impact of the downturn, pressure will be placed on these aid commitments. Several developing countries are heavily dependent on aid flows. Almost two-thirds of net capital inflows in Sub-Saharan Africa come from ODA, a significant reduction in these flows would compound the shocks from others pathways forcing the countries concerned to contract sharply.

There is therefore a strong case for meeting existing aid commitments to ensure that aid provides counter-cyclical relief to developing countries, rather than pro-cyclical distress. Many countries are already suffering depleted reserves as a result of the global food crisis earlier in the year.

Designing Appropriate Social Protection

In countries hard hit by the crisis, there is a strong case for the expansion of appropriate forms of social protection to minimise the impact on the poor. An external shock of this nature will have different effects – and therefore require a different response – from policies put in place to tackle drought, disasters, or health shocks. However, the need for a fast response means that adapting existing programs may be more effecting than creating new ones.

Fortunately there is useful experience from the Asian Financial Crisis in 1997/98 to draw on. The key lessons from that experience were:

Expand established safety net programmes rather than creating new ones.

Protect pro-poor spending (not only health and education, but infrastructure too)

Learn from other country experience about how to target social protection:

o a work requirement improved targeting in Argentina post-2001

o food subsidies can help the poor, but are often poorly targeted and therefore expensive, e.g. Indonesia post-1997

o unconditional cash transfers can be faster to roll out than more sophisticated conditional cash transfers such as PROGRESA in Mexico

Macroeconomic stability is important for the poor too. Policies to maintain price stability and employment levels are key.

The implementation of social protection programs depends on how the crisis affects aid. Much of Sub-Saharan Africa is heavily dependent on aid-funded social protection programs. Reductions in aid could both contract incomes and make populations more vulnerable. In Latin America – where most social protection programs are tax-funded and tax receipts are likely to reduce – it will be important for governments to prioritise social protection and pro-poor expenditures.

However, maintaining infrastructure expenditure can also be pro-poor – during Structural Adjustment in the 1980s many governments attempted to protect social sector expenditure by cutting investment and this resulted in slower growth as the capital stock degraded.

Towards a Fairer Financial Architecture

A new financial architecture is needed to reduce the vulnerability of developing countries to macro-economic shocks. The current crisis may be the worst financial crisis to hit the developed countries in 80 years but crises in developing countries are more common. In the last ten years major financial crises have affected Argentina, Brazil, Russia, and the East Asian countries to name only a few. There is a need for both better regulation in the financial sector and better prevention of the accumulation of large and unsustainable macroeconomic imbalances that give rise to crises.

If such a new architecture is to work, it must involve developing country governments in its design and implementation. This will clearly involve more rights (and greater responsibilities) for countries generating large surpluses – but it should not stop at this. Poor developing countries have played no role in creating the current crisis but they are likely to be significantly affected by it. A new system of international financial governance that institutionalises a mechanism for hearing the voices of poor countries, as well as larger and more ‘systemically important’ nations, is needed. The G20 grouping, although broader than the G8, includes only one country from Africa (South Africa) and not a single low income country.

Crises will still happen, even with a better framework for global financial governance. It is vital that the international community improves mechanisms for responding to crises when they occur. The US Federal Reserve’s currency swap scheme has played an important role in providing countries with immediate resources to support their currencies and the IMF has a Short-Term Liquidity Facility with similar aims. But the resources which are available under these schemes are limited and only available to a handful of countries.

For low-income countries the situation is even worse. The IMF’s External Shocks Facility provides loans to tackle shocks but resources are limited, there are strict eligibility criteria and high conditionality. The EU’s FLEX program attempts to achieve the same thing, but can take four years to disburse funds. Expanding such programs requires new sources of funding.

These might come from a new international tax (such as a Tobin tax, to penalise shortterm currency speculation); or they could come from higher contributions from large surplus nations. But to buy into such schemes, nations such as China would require a greater say in setting the agenda and mode of operation of institutions such as the IMF. The international community needs to use this extraordinary crisis as an opportunity to radically rewrite the rules of global financial governance to include the voices of the global poor.

Views from the South: An Overview

The global financial crisis is already beginning to have an impact on the ‘real economy’ in poorer countries around the world. However, the debate in rich countries about the impact of the crisis has largely ignored its impact on developing countries, and the voices of thinkers from these countries are rarely heard.

This briefing represents snapshots of the financial crisis as seen by 21 thinkers, academics and policymakers in 14 developing countries – brought together by the Institute of Development Studies.

As growth in these countries begins to slow their key concerns include reductions in exports, aid, remittances and foreign direct investment. They also explore three possible responses to the crisis: counter-cyclical spending, social protection and the creation of a new financial architecture.

The Impact of the Crisis Varies from Country to Country

Contributors from developing countries with relatively developed financial markets – India, Pakistan, Nigeria, Thailand, Brazil, South Africa, and the Philippines – have seen large falls in their stock markets. The Nigerian stock market has lost one third of its market capitalisation since the beginning of March; the Bombay Stock Exchange index is less than half of its previous peak; and the Sao Paulo Stock Exchange dropped by 60 per cent during October.

This has partly been caused by foreign investors attempting to repatriate their funds and a general flight to safety away from developing country markets which are perceived to be riskier. The Philippines has seen a reversal of net portfolio inflows of $500 million between January and September of this year, compared to a net inflow of US$ 3.4 billion in the same period last year. Sudden stops and reversals of external funding have affected exchange rates, leading to strong depreciations of domestic currencies: the Rand lost 35 per cent of its value between mid-September and mid-October; the Indian rupee hit a record low to the dollar.

However, despite this turmoil in the financial markets, many contributors state that the impact on their country so far has been remarkably limited to date – particularly those from the poorest countries. The relative lack of development of the financial sector in some countries may shield them from the worst of the crisis. For example, the Prime Minister of Ethiopia, one of the least monetised economies in the world, told Parliament ‘…we don’t expect drastic effects on our economy, [because] our financial structure is not as liberalized as those of affected countries…’. Even some countries with well developed financial markets, such as South Africa, have been able to weather the storm because their government finances and international reserve positions are healthy.

The issue is complicated by the declining price of oil and other commodities. Contributors from Ghana, Sri Lanka, and Kenya – countries dependent on commodity exports – express concern about the impact that this will have on growth. However, the decline in oil prices is seen as a positive factor in most countries, providing space for the authorities to expand domestic demand because of the weakening threat of inflation. Almost all contributors point to a significant and sometimes a drastic slowing of growth. Brazil was expected to grow 5.2 per cent in 2008, its forecast for 2009 has been repeatedly revised downwards to 2-3 per cent; South Africa’s growth rate will fall by slightly less than half; even Vietnam is only predicting growth of 6-6.5 per cent. This is particularly unfortunate since several developing countries had been experiencing their highest rates of growth for a decade prior to the crisis.

Four Common Concerns

Despite the variety of country circumstances, four concerns emerged strongly from almost all contributors. The concern that exports will decline, or, in many cases already have begun to decline, due to slow growth or recession in the US and some European countries. In Bangladesh, where ready-made garments account for twothirds of the country’s total annual export income, orders from Europe and the US dropped 7 per cent in September, even before the worst of the crisis hit.

The weakening performance of electronics and garments industries is a key concern in the Philippines, with year on year exports to the US down by 15 per cent. In Kenya, the cut flower industry is suffering as European customers are hit by the crisis. Declining revenue from tourism is also a key concern. Both Kenya and Thailand’s earnings from tourism have declined sharply in the past year. Political instability may be contributing, but the crisis is likely to exacerbate this trend.

The crisis will also impact on the price of exports – the private sector in Sri Lanka is concerned about the falling prices of rubber, tea, coconuts and garments. Vietnamese producers are concerned that price competition will intensify, as large producers such as China increase exports to other developing country markets.

The concern that aid will decline. Contributors, from African countries in particular, anticipate a fall in aid receipts from donor countries as they reprioritise expenditure. Private foundations are already scaling down their budget allocations and contributors from Kenya, Ghana and Ethiopia all expect a decline in official aid.

The concern that remittances will decline. There is strong concern about the impact of the crisis on remittances. The Philippines’ target for remittance income was US$15 billion in 2008 – this may be missed as Philippino workers abroad lose their jobs. In Kenya, orders for Mbuzi ya Jamii (goat for the family) are down sharply at online stores that allow Kenyans abroad to pay for products and services for their families back home. But location matters – Bangladesh’s 5 million expatriates are mostly based in the Middle East and Muslim countries less affected by the crisis, although this also may change as the oil price declines.

The concern that foreign direct investment will decline. In a few countries, the impact of the crisis on Foreign Direct Investment (FDI) is a significant concern. The Ethiopian Electric Power Corporation has indicated that its investment plans will be severely affected due to the crisis and in Vietnam, where FDI accounts for over a fifth of total investment, there is concern that planned investments may be postponed or cancelled.

Responses to the Crisis

Counter-cyclical spending will be key – but not always affordable. A noteworthy aspect of the responses was what was not said. Very few developing country governments appear to have given significant thought to how to respond to the impact of the crisis in the real sector, either in the form of fiscal stimulus, or the implementation of appropriate forms of social protection for those most affected. This is not surprising – attention has been focussed on responding to the extreme volatility in the financial and currency markets. But contributor’s concerns make it clear that effects on the real economy are likely to be felt soon.

Several respondents call for more government spending on infrastructure, health and education. In South Africa, the accumulated fiscal surplus may allow the government to increase social expenditure whilst continuing to invest in infrastructure. But most countries are not in a position to do this. Data from the Philippines suggests that the deficit is being reduced rather than expanded, and the contribution from Pakistan expresses concern about the implications of receiving IMF financing. From India, there are concerns that increases in social expenditure in the last budget (including the National Rural Employment Guarantee scheme) may not be sufficient to prevent recession in the future.

Developing countries need to implement appropriate social protection mechanisms now. Worryingly, not one of the 19 respondents pointed to efforts by their governments to implement social protection mechanisms to respond to the crisis. It is likely that in each country some groups will be affected by the crisis more than others.

From the East Asia crisis in 1997/1998, countries can learn about the types of social protection which are most effective in responding to macroeconomic shocks. But adapting existing social protection mechanisms to tackle a macroeconomic shock takes time, developing country governments need to start this process soon. This may be an area where donors can provide valuable support.

A new financial architecture is needed to reduce the vulnerability of developing countries to macroeconomic shocks. The current crisis may be the worst financial crisis to hit the developed countries in 80 years. But financial crises affecting developing countries are far from uncommon. In the last ten years, major financial crises have affected Argentina, Brazil, Russia, and the East Asian countries to name only a few. There is clearly a need, not only for better regulation in the financial sector, but also for improved ways of preventing the accumulation of large and unsustainable macroeconomic imbalances that give rise to crises. If such a new architecture is to work, it must involve developing country governments in its design and implementation. We hope that this report by compiling views from a wide range of thinkers from developing countries, can contribute to building a more sustainable architecture for sustainable growth and development.

Dr Neil McCulloch is a Fellow at the Institute of Development Studies at Sussex University.  

This text is taken from the introduction and summary of the report: Voices from the South - the Impact of the Financial Crisis on Developing Countries

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