The Financial Crisis and the Developing World Jayati Ghosh

The past two weeks have made it clear that the developing world is far from immune to the storms raging in financial markets in industrial countries. Stock prices in emerging markets have gone on similar roller coaster rides to those in New York and Europe. Indeed, they have shown such very high volatility, going sharply up and down on a daily basis around an overall declining trend, that the pattern is reminiscent of the behaviour of stock indices in the last major international financial upheaval in 1929/30 – the Great Depression. And the credit crunch and freezing of interbank lending have been only too evident even in developing countries whose economic “fundamentals” are apparently strong and whose policy makers believed that they could de-couple from the global trends.

This almost immediate diffusion of bad news is the result of financial liberalisation policies across the developing world that have made capital markets much more integrated directly through mobile capital flows, as well as created newer and similar forms of financial fragility almost everywhere. But the international transmission of turbulence is only one of the ways in which the global financial crisis can and will affect developing countries.

A medium-term implication is the impact on private capital flows to developing countries, which are likely to reduce with the credit crunch and with reduced appetite for risk among investors. The past five years witnessed an unprecedented increase in gross private capital flows to developing countries. Remarkably, however, this was not accompanied by a net transfer of financial resources, because all developing regions chose to accumulate foreign exchange reserves rather than actually use the money. Thus, there was an even more unprecedented counter-flow from South to North in the form of central bank investments in safe assets and sovereign wealth funds of developing countries, a process which completely shattered the notion that free capital markets generate net financial flows from rich to poor countries.

The likely reduction of capital flows into developing countries is generally perceived as bad news. But that is not necessarily true, since the earlier capital inflows were mostly not used for productive investment by the countries that received them. Instead, the external reserve build-up (which reflected attempts of developing countries to prevent their exchange rates from appreciating and to build a cushion against potential crises) proved quite costly for the developing world, in terms of interest rate differentials and unused resources. While some developing countries may indeed be adversely affected by the reduction in net capital inflows, for many other emerging markets thus may be a blessing in disguise as it reduces upward pressure on exchange rates and creates more emphasis on domestic resource mobilisation.

Similarly, it is also very likely that the crisis will reduce official development assistance to poor countries. It is well known that foreign aid is strongly pro-cyclical, in that developed countries’ “generosity” to poor countries is adversely affected by any reversal in their own economic fortunes. But in any case development aid has also been experiencing an overall declining trend over the past two decades, even during the recent boom.

In fact, the developed countries were extremely miserly even in providing debt relief to countries whose development prospects have been crippled by the need to repay large quantities of external debt that rarely contributed to actual growth. Notwithstanding the enormous international pressure for debt write-off, the G-8 countries have provided hardly any real debt relief. When they have done so, they have provided small amounts of relief along with very heavy and damaging policy conditionalities and in a blaze of self-serving publicity. So the speed and extent of the debt relief provided to their own large banks by the governments of the US and other developed countries, even when these banks have behaved far more irresponsibly, has not gone unnoticed in the developing world.

One major source of foreign exchange that will certainly be affected is remittance incomes, especially from workers based in Northern countries. Already, the Inter-American Development Bank estimates that 2008 will be the first year on record during which the real value of inward remittances will fall in Latin America and the Caribbean. Remittances into Mexico (which are dominantly from workers based in the US) in August were already down 12 per cent compared to a year previously, and this will only get worse. There is also evidence of declining remittances from other countries that relied strongly on them, such as the Philippines, Bangladesh, Lebanon, Jordan and Ethiopia. In India, where around half of inward remittances currently come from the US, the same pattern of decline is likely.

Exports of goods and services, like remittances, are going to be affected by the global economic downturn. For most developing countries, the US and the European Union remain the most important sources of final export demand, and as they inevitably tip into recession, exports to these markets will also decline. There has been much talk of China emerging as the alternative engine of growth for the world economy. But this is highly unlikely, for several reasons.

First, Chinese growth, which has pulled along many other Asian developing countries in a production chain, has been largely export-led. The US, EU and Japan together account for more than half of China’s exports, and as their economic crisis intensifies, it is bound to affect both exports and economic activity in China.

Second, even if China’s policy makers respond by shifting to an emphasis on the domestic economy, this is unlikely to generate levels of international demand that will come anywhere near to the meeting the shortfall created by recession in the developed countries. China’s share of global imports is still too small for it to serve as a growth engine on the same scale.

Fond hopes have been expressed by some western policy makers and economists, that China can use the $2 trillion of foreign reserves that it controls (directly and through Hong Kong SAR) to bail out the bankrupt US financial system. But these hopes are also misplaced. Certainly it is likely that eventually some of the shares purchased by the US Fed and Treasury in their troubled banks may be eventually auctioned off to Chinese and other sovereign wealth funds among other investors. But this is not anything like a solution to the basic problem of dealing with the “toxic assets” held by the various troubled financial institutions of the West, especially as even the full amount of such assets is still not known given the complicated entanglement of such institutions.

Across the developing world, one additional detrimental effect of the current crisis is likely to be the postponement or even cancellation of large investment projects whose ultimate profitability is now in doubt. This will have negative multiplier effects, as cancelled orders and lost jobs further reduce demand. The construction sector has already been hit, and many large projects are being cancelled even in economies that are still growing. The aviation sector is going through a major shakeout, which is evident even in India where there has already been a tendency towards mergers and worker retrenchment. The tourism and hospitality sector, which had emerged as an important employer in many developing countries, is facing cancellations and declining demand across both luxury and middle class segments.

The recent crisis has also signalled the end of the commodity boom, which is bad news for those developing countries dominantly reliant on commodity exports, and good news for commodity-importing developing countries. This follows a period of unprecedented increase in oil and other commodity prices, led largely by speculative investor behaviour. On 14 October oil prices (Brent Crude futures) fell to less than $75 per barrel from nearly $150 in early July. One important index of commodity prices, the Reuters-Jefferies CRB index, on 14 October was 40 per cent below its all-time high in July. While speculative behaviour was clearly behind the volatility in commodity prices over the past year, it is likely that such prices will continue to decline now because of the broader economic slowdown.

This may provide some breathing space in terms of inflation control for importing developing countries, especially oil importers. But remember that even at $75 a barrel, oil prices are still 300 per cent of their nominal level of only five years ago. And while world prices of important food items have also declined in the recent past, they are still too high for many developing countries with low per capita incomes and a large proportion of already hungry people. Indeed, the financial crisis may actually make it more difficult for many governments of poor developing countries to secure adequate commodity supplies to meet their people’s needs. The food crisis seems to have gone off the international media map, but it still rages for possibly a majority of the population of the developing world, and the current global economic crisis will certainly not make it better.

These are forces that will affect all or most developing countries, but they will be felt differently in different places. In particular, the extent of financial contagion and possible local financial crisis depends on how far the developing country concerned has gone along the road of financial liberalisation. It is worth noting that those countries that have gone furthest in terms of deregulating their financial markets along the lines of the US (for example Indonesia) have been the worst affected and may well have full blown financial crises of their own. By contrast, China, which has still kept most of the banking system under state control and has not allowed many of the financial “innovations” that are responsible for the current mess in developed markets, is relatively safe. In India, where we still have a nationalised banking system and greater degree of regulation, we are better off than Indonesia, but recent reforms that the NDA and UPA government have pushed through despite Left protests, along with our growing current account deficit, have rendered us more fragile and potentially vulnerable than China.

In addition, countries with large external debts and current account deficits will face particular problems. Already, it is apparent that financial markets are estimating the risk of default (in the form of the price of credit default swaps) for countries such as Pakistan, Argentina and Ukraine as high as 80 per cent or more. Sometimes, as in Kazakhstan and Latvia, it is because of their highly leveraged banking systems. In other cases, as for Turkey and Hungary, it is because of the very high current account deficits.

Of course, developing countries are still bit players in this global drama. This particular financial crisis has so many ramifications mainly because it is occurring in the very core of capitalism, and originated in the US, the country that had the global power and influence to impose its own economic model on almost all of the rest of the world. And the depth and severity of the crisis are likely to signal global political economy changes that will shape the world for the next few decades. Geopolitical shifts are likely to result from such glaring exposure of economic vulnerability in the global hegemon.

While the drama is still being played out and the ultimate denouement is still unclear, what cannot be denied is that US dominance of world economics and politics is now under severe question, and has suffered a blow from which it may not recover. There was certainly some symbolism in the fact that on the day when a Chinese man was walking in space for the first time, the US Treasury Secretary was down on his knees pleading for a bailout. The changes in the world in the next decade will not be linear or unidirectional, and there are bound to be savage conflicts over resources and much else, but the recent pattern of global imperialism has been severely disturbed.

This is not a conclusion that will be easily drawn in Washington, or even in Europe. Financial crises were things that happened in the developing world, after the breaking of which western officials, consultants and others could lecture the governments of the crisis-ridden countries on their past profligacy and wrong policies, and proceed to administer the severe “Washington Consensus” medicine that they felt was essential. Now, of course, the wrongdoing and the collapse are most evident in the US and Europe, and they are following the opposite of what they had prescribed for developing countries, by rescuing banks and going in for Keynesian countercyclical macroeconomic policies. So it should be difficult, at least for a while, for even the most hard-boiled and insensitive such western policy adviser to take the same high moral tone with developing countries as in the past.

The global financial and trading system is one that for many generations has been almost exclusively determined by the governments of western former colonial powers, and their writ still runs large in all the global institutions. Thus, the G-7 which leaves out Russia and China, not to mention India and Brazil, still presumes that it has the right to redesign the international financial architecture. The Financial Stability Forum of the Bank for International Settlements excludes any representation from developing countries. The tiny countries of Belgium, Netherlands and Luxembourg, with a total population of less than 28 million, have more votes in the IMF than China, Brazil or India.

But even more than the geopolitical or economic shift, a bigger shift may come about from the clear failure of the economic model of neoliberalism. The notions that markets know best, and that self-regulation is the best form of financial regulation, have now been completely exposed for the frauds that they are. And so this pervasive financial crisis, which is still to fully play out and work itself through in real economies, may have led to one very positive shift. It has created a genuine opportunity not only for questioning the economic paradigm that has been dominant for far too long, but also replacing it with more progressive and democratic alternatives.