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The Impact of the Current Financial Crisis on Developing Countries


Distinguished Speaker Seminar: Justin Yifu Lin – The Impact of the Current Financial Crisis on Developing Countries

Justin Yifu Lin, Chief Economist and Senior Vice President of the World Bank delivered a speech entitled "The Impact of The Current Financial Crisis on Developing Countries” at a distinguished speaker seminar on 20 October 2008.

He started with a brief discussion of the dynamics of global growth in 2002-2007, focusing on the mutually reinforcing booms in the developed and developing world. He raised some causal questions on the collapse of dynamism in developed countries and its effects on developing countries; as well as policy responses by both developing and developed economies to contain the damage which would be the continuing themes in his speech.

Dr. Lin explained that the expansion during 2002-2007 began with a bang; starting from the bursting of the United States (US) tech-stock bubble in 2000-2001 which had a substantial wealth effect on American households. To minimize the duration and depth of the ensuing recession, the Federal Reserve aggressively eased monetary policy. It lowered either the Federal Reserve funds rate or the discount rate 27 times between January 2001 and June 2003, with the funds rate falling from 6.5% to 1.0% over that period. In several other developed economies, apparent housing bubbles inflated, and in some cases even larger than the US bubble. As a result of this combination of policy and market psychology, the brief global recession of 2001-2002 was followed by a period of reasonably dynamic growth in the US and in much of the developed world, accompanied by low cost of capital.

Turning to developing countries, Dr. Lin said that past improvements in macroeconomic policies had lain the foundations for rapid growth in this decade. The developing world found its growth stoked by surges in foreign direct investments and other private flows, increased export revenues and remittances from workers abroad, and sharp increases in commodity prices which benefited many developing countries. Dr. Lin pointed out that from 2003 to 2007, developing-country growth exceeded 5% every year, peaking at 7%. By contrast, average annual growth for 1980-2000 had been just 3.4%. In the recent period, investment is estimated to have added about 4% points to annual GDP growth.

With the rapid growth in developing countries came the emergence of vulnerabilities, akin to those appearing in developed countries, represented by unsustainable double-digit increases in housing prices and twin deficits in the US, including large balance of payments deficit. These were exacerbated by financial innovations not being matched by adequate regulation, thereby compounding the vulnerabilities.

The recent financial collapse has been attributed to the source of dynamism in developed countries. This can be illustrated according to Dr. Lin in the bursting of the housing bubble which led to the crisis in sub-prime mortgage market. He argued that financial innovations amplified risk rather than sharing and dampening it. Although problems originated in the US, they were paralleled and had repercussions in other developed countries as shown by housing bubbles in many other countries.

The very same factors which spurred growth in developing countries prior to the crisis have turned to the opposite direction. These include falling inward FDI and portfolio investment—as seen in 2008—accompanied by higher interest rates on capital, fall in commodity prices, capital scarcity, and drop in remittances as developed country labor markets slacken. As funds become even more scarce, governments can hardly afford needed investments.

There could be second round effects on developing countries worsening the crisis, as effects may not be limited to an overall slowdown of GDP growth, plummeting investments, and export earnings. There is a danger that emerging markets could go through crises of their own, if their domestic housing and stock market bubbles burst with collateral damages exploding through the banking sector.

In addressing these problems, Dr. Lin suggested that developed countries must move quickly to reach consensus on sharing of costs of adjustment, and should continue the uninterrupted flow of aid and trade with developing countries. He also noted that as a matter of first priority it is crucial to prevent contagion to the financial sector so that the costs to developing countries are minimized. Monetary policy suggests that with the decline in commodity price and inflation, governments can use monetary easing to promote industrial upgrading in sectors with comparative advantage. In regard to fiscal policy, finance creation and upgrading of infrastructure are useful for catching up with the private sector that had enjoyed rapid growth during the pre-crisis period. Governments should fund social safety nets, and investments in education and health should be viewed in terms of improving future economic productivity. More importantly, governments should increase counter-cyclical demands, such as investments in infrastructure and structural development, to the extent that is consistent with protecting domestic fundamentals. Well thought out infrastructure projects can provide payoffs that recover the cost of investments. As capital markets run dry, it is in this particular situation that the World Bank can play a crucial role by ramping up lending.

Dr. Lin cited the case of the People's Republic of China (PRC) as an example where infrastructure investment is also viewed as important in sustaining growth in the face of the global slowdown. There is a strong need for infrastructure to link urban and rural areas, allowing the latter to expand greatly. Because the PRC has very high savings and reserve assets, it is in a good position to make additional infrastructure investments. Growth in infrastructure investment can increase 10-15% each year. Dr Lin also mentioned examples of countries with high savings reflected in their huge sovereign wealth funds. These funds, he suggested, should remain open to long-term investments with respectable returns (such as infrastructure).

Dr. Lin ended by suggesting that governments should consider carefully whether to also utilize monetary policy to control asset price inflation. He added that financial supervision should be based on the recognition that innovations can also do damage. Responses to global crises must be systematic, comprehensive, decisive, and coordinated. He added that when we try new multilateral solutions to the global problems, creativity and willingness would be essential.