Institute of Development Studies

A New Era in the Global Economy?

The Implications of the Current Global Financial Crisis for Developing Countries

Ricardo Gottschalk – 06 October 2008

For the first time in many years a financial crisis with global repercussions has been originated at the heart of the global financial system and it will have major implications for the developing world. Three challenges face emerging market economies and low-income countries in the wake of the crisis both over the short- and the medium- to long-terms.

In the short-term, the major challenge is how best to respond if, as seems likely, there is an economic recession in the developed world. In the medium- to long-term, two further challenges arise. The first is what integration strategy should developing countries pursue within the global financial system? The second is what role should larger emerging market economies aim or expect to play in a new global financial system that is likely to emerge with the demise of the current one.

Can developing countries avoid the end of de-coupling?

An economic recession in the rich countries, if deep and prolonged, will certainly affect the current economic performance of developing countries. Developing country growth already seems to be decelerating, partly as a result of the current slow down in the US and Europe. This trend will probably be reinforced if the slowdown becomes a full-blown recession.

The first impact will be rapidly declining demand for exports from the rich countries. The second round effects will happen because of the impacts on China – the most important dynamic pole within the developing world. So far, China’s continuing dynamism has sustained demand for manufacturing inputs from around East and South-east Asia and primary commodities from Africa and Latin America, thereby counter-balancing the slowdown in the rich countries. Although unlikely, a strong slowdown in China’s growth would bring the current dynamism among developing countries to an end.

The above effects are linked to trade. However, the crisis may impact the developing world through financial channels as well. Developing countries are still growing fast and attracting international capital flows. But as the crisis deepens and uncertainty among international investors heightens, a major capital reversal may take place as investors look for safer places for their capital.

This could be a particular problem for developing economies that are already vulnerable to capital reversals due to their large current account deficits – as is the case in Eastern Europe and some Latin American countries. Sub-Saharan Africa does not attract significant portfolio capital, but in many countries foreign direct investment (FDI) has been playing an important role, and this could decline as well. Moreover, most countries in the sub-region are aid dependent. If rich countries enter into deep recession and reduce their aid budgets, then Sub-Saharan Africa will be hit by reduced aid as well.

The magnitude of the impacts will depend on how developing countries respond to the changing conditions in the world economy. Today, unlike in previous crises, many emerging market economies have large amounts of international reserves and balanced fiscal positions, giving them the financial and fiscal space to stimulate domestic demand and compensate for a declining external demand for exports. Moreover, in many cases their domestic financial systems are in healthy conditions and thus able to support their economies’ growth through continued credit provision to consumers and the corporate sectors. However, the room for manoeuvre may be restricted by the threat of inflation, which in some countries has been rising due to the oil and food price shocks.

Individual policy responses will depend on the particular domestic market conditions facing each country, the importance attached to possible trade-offs between growth and inflation, and how these are dealt with.

In the current financial meltdown, is it wise to pursue further capital account liberalisation, or should developing countries take a more cautionary strategy?

Before the current financial crisis, emerging market economies, such as Brazil, China, India and South Africa, were debating plans for further liberalisation of their capital accounts. Since in most cases inflows for different categories of capital had already been liberalised considerably, these plans were aimed at liberalising mainly capital outflows by residents. The policy goals underlying further liberalisation differed from country to country, but the ultimate consequence would be to permit domestic savers to pursue international portfolio diversification – therefore allowing major shifts away from domestic and towards foreign assets.

Among low-income countries, which in many cases still have restricted capital accounts on the inflows side, the policy issue has been how to go about liberalising portfolio inflows in order to meet their external financing needs and strengthen their still incipient capital markets to boost the financing opportunities of their domestic companies.

In the current financial meltdown, the question is whether it is wise to pursue further capital account liberalisation, or whether developing countries should instead take a more cautionary strategy. Previous crises have shown that developing countries can be vulnerable to highly volatile international capital flows even when their ‘fundamentals’ look alright.

Volatile capital flows can cause a lot of distress to their domestic economies – this may take the form of a rapid deterioration in their macroeconomic variables and their firms’ balance sheets. For example, rapid capital reversal can cause a sharp depreciation in domestic currency, immediately affecting a country’s ability to meet its external debt obligations, especially if its external debt is large.

Currency depreciation also affects the financial positions of a country’s firms facing large currency mismatches in their balance sheets, for example with firms holding debts in foreign currencies but generating revenues mainly in domestic currency. The East Asian crisis 11 years ago showed us that these large mismatches increase the credit risk faced by banks that had lent to these firms, which in turn affect the banks’ stability.

The potential risks outlined above are mainly associated with liberalisation of capital inflows, but caution is also necessary on plans to liberalise capital on the outflows side. International portfolio diversification by residents would not be advisable while there is so much uncertainty about the dollar – which is still the reserve currency of the world. What will happen to the value of international assets denominated in dollars and in other currencies? How volatile will these be until a new world reserve currency replaces the dollar? What international assets will be safe to hold in times of high turbulence and change? 

What is the role for developing countries in a new global financial system?

Since the current crisis there has been a call to introduce a global financial regulator – in which larger emerging market economies should have an active role. This role is important as emerging economies become responsible for significant shares of global output and international trade. These economies currently hold large amounts of western assets, forming part of their international reserves and sovereign wealth funds, although some of these are also held by domestic private agents.

So far in the current crisis, emerging economy investment decisions have been positive for global financial stability. Sovereign wealth funds from emerging markets have already helped rescue western banks, and this role is expected to continue. However, developing country central banks and sovereign wealth funds hold large amounts of US dollar denominated assets. If the dollar depreciates sharply there could be a rapid protective shift towards assets in other currencies. This would accelerate the decline of the dollar and contribute to further instability.

My final question is whether emerging market economies, or at least East Asia, are ready to break the global hegemony of the western banks? Japanese banks are already buying parts of collapsed western banks and China’s banks may also embark on major acquisitions of their western counterparts. It is still to be seen whether the current Eastern dominance in manufacturing will extend to the financial sector. Are East Asian banks ready to take the lead on the provision of highly sophisticated financial products and financial innovation? If they can, then it will truly mark the beginning of a new era in the global economy.

Ricardo Gottschalk is a Research Fellow in the Globalisation Team at IDS

Image: Natalie Behring/ Panos