CHAPTER 1:

INTRODUCTION:
WHAT IS FINANCIAL CRISES?

The term financial crisis is applied broadly to a variety of situations in which some financial
institutions or assets suddenly lose a large part of their value. In the 19th and early 20th
centuries, many financial crises were associated with banking panics, and
many recessions coincided with these panics. Other situations that are often called financial
crises include stock market crashes and the bursting of other financial bubbles, currency
crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth; they
do not directly result in changes in the real economy unless a recession or depression follows.

Another definition is as follows:

It is a situation in which the supply of money is outpaced by the demand for money.

This means that liquidity is quickly evaporated because available money is withdrawn
from banks (called a run), forcing banks either to sell other investments to make up for the
shortfall.

CURRENT SENARIO:

The financial crisis of 2007 to the present was triggered by a liquidity shortfall in the United
States banking system. It has resulted in the collapse of large financial institutions,
the bailout of banks by national governments, and downturns in stock markets around the
world. In many areas, the housing market has also suffered, resulting in
numerous evictions, foreclosures and prolonged vacancies. It is considered by many
economists to be the worst financial crisis since the Great Depression of the 1930s. It
contributed to the failure of key businesses, declines in consumer wealth estimated in the
hundreds of billions of U.S. dollars, substantial financial commitments incurred by
governments, and a significant decline in economic activity. Many causes have been
suggested, with varying weight assigned by experts. Both market-based and regulatory
solutions have been implemented or are under consideration, while significant risks remain
for the world economy over the 2010–2011 periods.

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The collapse of the housing bubble, which peaked in the U.S. in 2006, caused the values
of securities tied to real estate pricing to plummet thereafter, damaging financial institutions
globally. Questions regarding bank solvency, declines in credit availability, and damaged
investor confidence had an impact on global stock markets, where securities suffered large
losses during late 2008 and early 2009. Economies worldwide slowed during this period as
credit tightened and international trade declined. Critics argued that credit rating agencies and
investors failed to accurately price the risk involved with mortgage-related financial products,
and that governments did not adjust their regulatory practices to address 21st century
financial markets. Governments and central banks responded with unprecedented fiscal
stimulus, monetary policy expansion, and institutional bailouts.

TYPES OF FINANCIAL CRISES:

Banking crisis

When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run.
Since banks lend out most of the cash they receive in deposits (see fractional-reserve
banking), it is difficult for them to quickly pay back all deposits if these are suddenly
demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their
savings unless they are covered by deposit insurance. A situation in which bank runs are
widespread is called a systemic banking crisis or just a banking panic. A situation without
widespread bank runs, but in which banks are reluctant to lend, because they worry that they
have insufficient funds available, is often called a credit crunch. In this way, the banks
become an accelerator of a financial crisis.

Speculative bubbles and crashes

Economists say that a financial asset (stock, for example) exhibits a bubble when its price
exceeds the present value of the future income (such as interest or dividends) that would be
received by owning it to maturity. If most market participants buy the asset primarily in
hopes of selling it later at a higher price, instead of buying it for the income it will generate,
this could be evidence that a bubble is present. If there is a bubble, there is also a risk of
a crash in asset prices: market participants will go on buying only as long as they expect
others to buy, and when many decide to sell the price will fall. However, it is difficult to tell

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in practice whether an asset's price actually equals its fundamental value, so it is hard to
detect bubbles reliably. Some economists insist that bubbles never or almost never occur.

Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and
other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese
property bubbleof the 1980s, the crash of the dot-com bubble in 2000-2001, and the now-
deflating United States housing bubble.

International financial crises

When a country that maintains a fixed exchange rate is suddenly forced to devalue its
currency because of a speculative attack, this is called acurrency crisis or balance of
payments crisis. When a country fails to pay back its sovereign debt, this is called
a sovereign default. While devaluation and default could both be voluntary decisions of the
government, they are often perceived to be the involuntary results of a change in investor
sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight.

Several currencies that formed part of the European Exchange Rate Mechanism suffered

crises in 1992-93 and were forced to devalue or withdraw from the mechanism. Another
round of currency crises took place in Asia in 1997-98. Many Latin American countries
defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a
devaluation of the ruble and default on Russian government bonds.

Wider economic crises

Negative GDP growth lasting two or more quarters is called a recession. An especially
prolonged recession may be called a depression, while a long period of slow but not
necessarily negative growth is sometimes called economic stagnation.

Since these phenomena affect much more than the financial system, they are not usually
considered financial crises per se. But some economists have argued that many recessions
have been caused in large part by financial crises. One important example is the Great
Depression, which was preceded in many countries by bank runs and stock market crashes.
The subprime mortgage crisis and the bursting of other real estate bubbles around the world
has led to recession in the U.S. and a number of other countries in late 2008 and 2009.

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Nonetheless, some economists argue that financial crises are caused by recessions instead of
the other way around. Also, even if a financial crisis is the initial shock that sets off a
recession, other factors may be more important in prolonging the recession.

CAUSES AND CONSEQUENCES:

Strategic complementarities in financial markets

It is often observed that successful investment requires each investor in a financial market to
guess what other investors will do. George Soros has called this need to guess the intentions
of others 'reflexivity'. Similarly, John Maynard Keynes compared financial markets to a
beauty contest game in which each participant tries to predict which model other participants
will consider most beautiful.

Furthermore, in many cases investors have incentives to coordinate their choices. For
example, someone who thinks other investors want to buy lots of Japanese yen may expect
the yen to rise in value, and therefore has an incentive to buy yen too. Likewise, a depositor
in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank
to fail, and therefore has an incentive to withdraw too. Economists call an incentive to mimic
the strategies of others strategic complementarity.

It has been argued that if people or firms have a sufficiently strong incentive to do the same
thing they expect others to do, then self-fulfilling prophecies may occur. For example, if
investors expect the value of the yen to rise, this may cause its value to rise; if depositors
expect a bank to fail this may cause it to fail. Therefore, financial crises are sometimes
viewed as a vicious circle in which investors shun some institution or asset because they
expect others to do so.

Leverage

Leverage, which means borrowing to finance investments, is frequently cited as a contributor

to financial crises. When a financial institution (or an individual) only invests its own money,
it can, in the very worst case, lose its own money. But when it borrows in order to invest
more, it can potentially earn more from its investment, but it can also lose more than all it
has. Therefore leverage magnifies the potential returns from investment, but also creates a

4
risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised
payments to other firms, it may spread financial troubles from one firm to another

The average degree of leverage in the economy often rises prior to a financial crisis. For
example, borrowing to finance investment in the stock market ("margin buying") became
increasingly common prior to the Wall Street Crash of 1929.

Asset-liability mismatch

Another factor believed to contribute to financial crises is asset-liability mismatch, a situation

in which the risks associated with an institution's debts and assets are not appropriately
aligned. For example, commercial banks offer deposit accounts which can be withdrawn at
any time and they use the proceeds to make long-term loans to businesses and homeowners.
The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets
(its loans) is seen as one of the reasons bank runs occur (when depositors panic and decide to
withdraw their funds more quickly than the bank can get back the proceeds of its loans).[14]
Likewise, Bear Stearns failed in 2007-08 because it was unable to renew the short-term debt
it used to finance long-term investments in mortgage securities.

In an international context, many emerging market governments are unable to sell bonds
denominated in their own currencies, and therefore sell bonds denominated in US dollars
instead. This generates a mismatch between the currency denomination of their liabilities
(their bonds) and their assets (their local tax revenues), so that they run a risk of sovereign
default due to fluctuations in exchange rates.[16]

Uncertainty and herd behavior

Many analyses of financial crises emphasize the role of investment mistakes caused by lack
of knowledge or the imperfections of human reasoning. Behavioral finance studies errors in
economic and quantitative reasoning. Psychologist Torbjorn K A Eliazonhas also analyzed
failures of economic reasoning in his concept of 'œcopathy'.

Historians, notably Charles P. Kindleberger, have pointed out that crises often follow soon
after major financial or technical innovations that present investors with new types of
financial opportunities, which he called "displacements" of investors' expectations.[18][19] Early
examples include the South Sea Bubble and Mississippi Bubble of 1720, which occurred

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when the notion of investment in shares of company stock was itself new and unfamiliar, and
the Crash of 1929, which followed the introduction of new electrical and transportation
technologies. More recently, many financial crises followed changes in the investment
environment brought about by financial deregulation, and the crash of the dot com bubble in
2001 arguably began with "irrational exuberance" about Internet technology.

Unfamiliarity with recent technical and financial innovations may help explain how investors
sometimes grossly overestimate asset values. Also, if the first investors in a new class of
assets (for example, stock in "dot com" companies) profit from rising asset values as other
investors learn about the innovation (in our example, as others learn about the potential of the
Internet), then still more others may follow their example, driving the price even higher as
they rush to buy in hopes of similar profits. If such "herd behavior" causes prices to spiral up
far above the true value of the assets, a crash may become inevitable. If for any reason the
price briefly falls, so that investors realize that further gains are not assured, then the spiral
may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in
prices.

Regulatory failures

Governments have attempted to eliminate or mitigate financial crises by regulating the

financial sector. One major goal of regulation is transparency: making institutions' financial
situations publicly known by requiring regular reporting under standardized accounting
procedures. Another goal of regulation is making sure institutions have sufficient assets to
meet their contractual obligations, through reserve requirements, capital requirements, and
other limits on leverage.

Some financial crises have been blamed on insufficient regulation, and have led to changes in
regulation in order to avoid a repeat. For example, the Managing Director of the IMF,
Dominique Strauss-Kahn, has blamed the financial crisis of 2008 on 'regulatory failure to
guard against excessive risk-taking in the financial system, especially in the US'. Likewise,
the New York Times singled out the deregulation of credit default swaps as a cause of the
crisis.

However, excessive regulation has also been cited as a possible cause of financial crises. In
particular, the Basel II Accord has been criticized for requiring banks to increase their capital

6
when risks rise, which might cause them to decrease lending precisely when capital is scarce,
potentially aggravating a financial crisis.

Fraud

Fraud has played a role in the collapse of some financial institutions, when companies have
attracted depositors with misleading claims about their investment strategies, or have
embezzled the resulting income. Examples include Charles Ponzi's scam in early 20th century
Boston, the collapse of the MMM investment fund in Russia in 1994, the scams that led to
the Albanian Lottery Uprising of 1997, and the collapse of Madoff Investment Securities in
2008.

Many rogue traders that have caused large losses at financial institutions have been accused
of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been
cited as one possible cause of the 2008 subprime mortgage crisis; government officials stated
on September 23, 2008 that the FBI was looking into possible fraud by mortgage financing
companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American
International Group.

Contagion

Contagion refers to the idea that financial crises may spread from one institution to another,
as when a bank run spreads from a few banks to many others, or from one country to another,
as when currency crises, sovereign defaults, or stock market crashes spread across countries.
When the failure of one particular financial institution threatens the stability of many other
institutions, this is called systemic risk.

One widely-cited example of contagion was the spread of the Thai crisis in 1997 to other
countries like South Korea. However, economists often debate whether observing crises in
many countries around the same time is truly caused by contagion from one market to
another, or whether it is instead caused by similar underlying problems that would have
affected each country individually even in the absence of international linkages.

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Recessionary effects

Some financial crises have little effect outside of the financial sector, like the Wall Street
crash of 1987, but other crises are believed to have played a role in decreasing growth in the
rest of the economy. There are many theories why a financial crisis could have a recessionary
effect on the rest of the economy. These theoretical ideas include the 'financial accelerator',
'flight to quality' and 'flight to liquidity', and the Kiyotaki-Moore model. Some 'third
generation' models of currency crises explore how currency crises and banking crises
together can cause recessions.

THEROIES OF FINANCIAL CRISES

Marxist theories:

Recurrent major depressions in the world economy at the pace of 20 and 50 years (often
referred to as the business cycle) have been the subject of studies since Jean Charles Léonard
de Sismondi (1773–1842) provided the first theory of crisis in a critique of classical political
economy's assumption of equilibrium between supply and demand. Developing an economic
crisis theory become the central recurring concept throughout Karl Marx's mature work.
Marx's law of the tendency for the rate of profit to fall borrowed many features of the
presentation of John Stuart Mill's discussion Of the Tendency of Profits to a Minimum .The
theory is a corrollary of the Tendency towards the Centralization of Profits.

In a capitalist system, successfully-operating businesses return less money to their workers

(in the form of wages) than the value of the goods produced by those workers (ie. the amount
of money the products are sold for). This profit first goes towards covering the initial
investment in the business. In the long-run, however, when one considers the combined
economic activity of all successfully-operating business, it is clear that less money (in the
form of wages) is being returned to the mass of the population (the workers) than is available
to them to buy all of these goods being produced. Furthermore, the expansion of businesses
in the process of competing for markets leads to an abundance of goods and a general fall in
their prices.

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The viability of this theory depends upon two main factors: firstly, the degree to which profit
is taxed by government and returned to the mass of people in the form of welfare, family
benefits and health and education spending; and secondly, the proportion of the population
who are workers rather than investors/business owners Given the extraordinary capital
expenditure required to enter modern economic sectors like airline transport, the military
industry, or chemical production, these sectors are extremely difficult for new businesses to
enter and are being concentrated in fewer and fewer hands.

Empirical and econometric research continue especially in the world systems theory and in
the debate about Nikolai Kondratiev and the so-called 50-years Kondratiev waves. Major
figures of world systems theory, like Andre Gunder Frank and Immanuel Wallerstein,
consistently warned about the crash that the world economy is now facing [citation needed]. World
systems scholars and Kondratiev cycle researchers always implied that Washington
Consensus oriented economists never understood the dangers and perils, which leading
industrial nations will be facing and are now facing at the end of the long economic cycle
which began after the oil crisis of 1973.

Minsky's theory:

Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed
economy. He theorized that financial fragility is a typical feature of any capitalist
economy[citation needed]. High fragility leads to a higher risk of a financial crisis. To facilitate his
analysis, Minsky defines three approaches to financing firms may choose, according to their
tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi
finance leads to the most fragility.

 for hedge finance, income flows are expected to meet financial obligations in every
period, including both the principal and the interest on loans.
 for speculative finance, a firm must roll over debt because income flows are expected
to only cover interest costs. None of the principal is paid off.
 for Ponzi finance, expected income flows will not even cover interest cost, so the firm
must borrow more or sell off assets simply to service its debt. The hope is that either
the market value of assets or income will rise enough to pay off interest and principal.

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Financial fragility levels move together with the business cycle. After a recession, firms have
lost much financing and choose only hedge, the safest. As the economy grows and expected
profits rise, firms tend to believe that they can allow themselves to take on speculative
financing. In this case, they know that profits will not cover all the interest all the time.
Firms, however, believe that profits will rise and the loans will eventually be repaid without
much trouble. More loans lead to more investment, and the economy grows further. Then
lenders also start believing that they will get back all the money they lend. Therefore, they are
ready to lend to firms without full guarantees of success.

Lenders know that such firms will have problems repaying. Still, they believe these firms will
refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way,
the economy has taken on much risky credit. Now it is only a question of time before some
big firm actually defaults. Lenders understand the actual risks in the economy and stop giving
credit so easily. Refinancing becomes impossible for many, and more firms default. If no new
money comes into the economy to allow the refinancing process, a real economic crisis
begins. During the recession, firms start to hedge again, and the cycle is closed.

Coordination games:

Mathematical approaches to modeling financial crises have emphasized that there is often
positive feedback between market participants' decisions .Positive feedback implies that there
may be dramatic changes in asset values in response to small changes in economic
fundamentals. For example, some models of currency crises imply that a fixed exchange rate
may be stable for a long period of time, but will collapse suddenly in an avalanche of
currency sales in response to a sufficient deterioration of government finances or underlying
economic conditions.

According to some theories, positive feedback implies that the economy can have more than
one equilibrium. There may be an equilibrium in which market participants invest heavily in
asset markets because they expect assets to be valuable, but there may be another equilibrium
where participants flee asset markets because they expect others to flee too. This is the type
of argument underlying Diamond and Dybvig's model of bank runs, in which savers
withdraw their assets from the bank because they expect others to withdraw too. Likewise, in
Obstfeld's model of currency crises, when economic conditions are neither too bad nor too

10
good, there are two possible outcomes: speculators may or may not decide to attack the
currency depending on what they expect other speculators to do.[

Herding models and learning models:

A variety of models have been developed in which asset values may spiral excessively up or
down as investors learn from each other. In these models, asset purchases by a few agents
encourage others to buy too, not because the true value of the asset increases when many buy
(but because investors come to believe the true asset value is high when they observe others
buying.

In "herding" models, it is assumed that investors are fully rational, but only have partial
information about the economy. In these models, when a few investors buy some type of
asset, this reveals that they have some positive information about that asset, which increases
the rational incentive of others to buy the asset too. Even though this is a fully rational
decision, it may sometimes lead to mistakenly high asset values (implying, eventually, a
crash) since the first investors may, by chance, have been mistaken.

In "adaptive learning" or "adaptive expectations" models, investors are assumed to be

imperfectly rational, basing their reasoning only on recent experience. In such models, if the
price of a given asset rises for some period of time, investors may begin to believe that its
price always rises, which increases their tendency to buy and thus drives the price up further.
Likewise, observing a few price decreases may give rise to a downward price spiral, so in
models of this type large fluctuations in asset prices may occur. Agent-based models of
financial markets often assume investors act on the basis of adaptive learning or adaptive
expectations.

HISTORY:

A noted survey of financial crises is This Time is Different: Eight Centuries of Financial
Folly (Reinhart & Rogoff 2009), by economists Carmen Reinhart and Kenneth Rogoff, who
are regarded as among the foremost historians of financial crises.In this survey, they trace the
history of financial crisis back to sovereign defaults – default on public debt, – which were

11
the form of crisis prior to the 18th century and continue, then and now causing private bank
failures; crises since the 18th century feature both public debt default and private debt
default. Reinhart and Rogoff also class debasement of currency and hyperinflation as being
forms of financial crisis, broadly speaking, because they lead to unilateral reduction
(repudiation) of debt.

Prior to 19th century

Reinhart and Rogoff trace inflation (to reduce debt) to Dionysius of Syracuse, of the 4th
century BCE, and begin their "eight centuries" in 1258; debasement of currency also occurred
under the Roman empire and Byzantine empire.

Among the earliest crises Reinhart and Rogoff study is the 1340 default of England, due to
setbacks in its war with France (the Hundred Years' War; see details). Further early sovereign
defaults include seven defaults by imperial Spain, four under Philip II, three under his
successors.

Other global and national financial mania since the 17th century include:

 1637: Bursting of tulip mania* in the Netherlands – while tulip mania is popularly
reported as an example of a financial crisis, and was a speculative bubble, modern
scholarship holds that its broader economic impact was limited to negligible, and that
it did not precipitate a financial crisis.
 1720: Bursting of South Sea Bubble (Great Britain) and Mississippi Bubble (France)
– earliest of modern financial crises; in both cases the company assumed the national
debt of the country (80–85% in Great Britain, 100% in France), and thereupon the
bubble burst.
 Crisis of 1772
 Panic of 1792
 Panic of 1796–1797

19th century:

 Danish state bankruptcy of 1813

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  Panic of 1819 – pervasive USA economic recession w/ bank failures; culmination of
U.S.'s 1st boom-to-bust economic cycle
 Panic of 1825 – pervasive British economic recession in which many British banks
failed, & Bank of England nearly failed
 Panic of 1837 – pervasive USA economic recession w/ bank failures; a 5 yr
depression ensued
 Panic of 1847 - a collapse of British financial markets associated with the end of the
1840s railroad boom.
 Panic of 1857 – pervasive USA economic recession w/ bank failures
 1866: Overend Gurney crisis – comprised the Panic of 1866 (primarily British)
 Panic of 1873 – pervasive USA economic recession w/ bank failures, known then as
the 5 yr Great Depression & now as the Long Depression
 Panic of 1884
 Panic of 1890
 Panic of 1893 – a panic in the United States marked by the collapse of railroad
overbuilding and shaky railroad financing which set off a series of bank failures
 Australian banking crisis of 1893
 Panic of 1896 - an acute economic depression in the United States precipitated by a
drop in silver reserves and market concerns on the effects it would have on the gold
standard

20th century:

 Panic of 1901 – limited to crashing of the New York Stock Exchange

 Panic of 1907 – pervasive USA economic recession w/ bank failures
 Panic of 1910–1911
 1910 – Shanghai rubber stock market crisis
 Wall Street Crash of 1929, followed by the Great Depression – the largest and most
important economic depression in the 20th century
 1973 – 1973 oil crisis – oil prices soared, causing the 1973–1974 stock market crash
 Secondary banking crisis of 1973–1975 – United Kingdom
 1980s – Latin American debt crisis – beginning in Mexico in 1982 with the Mexican
Weekend

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 Bank stock crisis (Israel 1983)
 1987 – Black Monday (1987) – the largest one-day percentage decline in stock market
history
 1989–91 – United States Savings & Loan crisis
 1990 – Japanese asset price bubble collapsed
 early 1990s – Scandinavian banking crisis: Swedish banking crisis, Finnish banking
crisis of 1990s
 1992–93 – Black Wednesday – speculative attacks on currencies in the European
Exchange Rate Mechanism
 1994–95 – 1994 economic crisis in Mexico – speculative attack and default on
Mexican debt
 1997–98 – 1997 Asian Financial Crisis – devaluations and banking crises across Asia
 1998 Russian financial crisis

21st century

 2001 – Bursting of dot-com bubble – speculations concerning internet companies

crashed
 2007–10 – Financial crisis of 2007–2010, followed by the late 2000s recession and
the 2010 European sovereign debt crisis.

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CHAPTER 2:
NEED OF THE STUDY:

 Financial crises is a major threat to developing countries.

 In order to know the various factors that causes in developing countries such as India,
China etc.

15
CHAPTER 3:

SCOPE OF THE STUDY:

 Gathering information & theoretical knowledge is a part of the study.

 It helps in getting a critical look in field of research and to know the various causes
that create financial crises in developing countries.

 The scope is limited to developing countries with reference to the objective stated
above.

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CHAPTER 4:

OBJECTIVE OF THE STUDY:

 Primary objective - A study on financial crises in developing countries.

 Secondary –

 To gain an overall idea about financial crises.

 To know the various research methodologies involved.

 To know about various factors that cause financial crises in developing

countries.

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CHAPTER 5:
IMPACT OF THE FINANCIAL CRISIS ON DEVELOPING COUNTRIES:

Throughout this crisis that has so consumed the attention of the world in recent
months, we have watched with grave concern as it cascaded outwards from the sectors
originally affected. Instability has surged from sector to sector, first from housing into
banking and other financial markets, and then on into all parts of the real economy. The crisis
has surged across the public-private boundary, as the hit to private firms' balance sheets has
now imposed heavy new demands on the public sector's finances. It has surged across
national borders within the developed world, as the people of Iceland know all too well. And
now there are reasons to fear that the crisis will swamp emerging markets and other
developing countries, cutting into the considerable economic progress of recent years.

Impact on developing countries

One effect will be a substantial reduction in their exports, as the rapid pace of trade expansion
of this decade decelerates sharply. The IMF recently projected growth in world trade volumes
of just 4.1 % in 2009, down from 9.3 % as recently as 2006; in our own more recent
projections, the deceleration is much more rapid and could in fact lead trade volumes to fall
in 2009 (World Bank Forthcoming). While the fall in export volume growth is projected to be
greater for advanced economies than for developing economies, the latter may also suffer
more from declines in the terms of trade – especially in the case of commodity exporters,
given that we expect non-oil commodity prices to fall by perhaps one-fifth in 2009.

In addition, the crisis will deal a negative shock to investment in emerging markets. All of the
main external sources of funds for investment are likely to drop off sharply in the first round

18
of effects. Portfolio investment will fall, as greater risk aversion keeps capital closer to home.
While FDI is historically more resilient to shocks, it too is expected to decline. In addition,
developing countries that are able to gain access to capital will pay higher interest rates,
because of the flight to safety and greater risk aversion of lenders. As noted above, the global
slowdown will reduce demand for commodities and manufactured goods, cutting into export
earnings. And as labour markets slacken, foreign workers are likely to suffer disproportionate
impacts on their earnings, which will reduce remittances. About half of all developing
countries have been running current account deficits of 5 % of GDP or more, and in some
cases the deficits are around 10 %. These economies will be highly vulnerable to swings in
these various sources in external financing. Overall, we now expect investment in middle-
income countries in 2009 to grow at less than half the 2007 rate of 13 %.

Second round effects will likely deepen the slowdown. Because of the investment surge of
the past five years, an especially large number of investment projects are already underway.
As investment financing drops off, two outcomes are possible, neither of them attractive. In
some cases, the projects will not be completed, making them unproductive and saddling
banks' balance sheets with non-performing loans. In other cases, when the projects are
completed, they will add to the excess production capacity that will result from the global
slowdown, and thereby add to the risk of deflation.

As a result of all these factors, we now expect that developing countries' collective GDP
growth will decline to less than 5 %, compared with an average of more than 7 % in 2004-07.
Moreover, the effects on developing countries may not be limited to a drop in investment and
export earnings and a slowdown of GDP growth. There is a distinct danger that emerging
markets could go through crises of their own, for example if their own domestic asset-market
bubbles burst (or even if fair-market values collapse) and weaken their own banking sectors.

Issues

Many developing countries enter this crisis with advantages that they lacked during the
shocks of the 1980s or 1990s. The strengthening of macroeconomic policies – including
fiscal and external positions, in many cases – leaves them less vulnerable.

The first priority is to prevent financial contagion from crippling domestic banking and non-
banking financial sectors. Because of the high level of interlinkages among the world's

19
financial firms and sectors, these effects have begun to arrive before the real-economy effects
in some countries. Stock markets have declined sharply, some currencies have depreciated
substantially, and sovereign interest-rate spreads have risen with the "flight to safety" in
world markets. At a more micro level, some developing-country exporters are already finding
it hard to obtain the trade credits that are their lifeblood, which could cripple export sectors
that will soon be hit by the fall in foreign demand.

So just like in the developed countries, it is important that the developing countries take
quick, decisive, and systematic measures to ensure that credit crunches and bank collapses
are avoided locally. And in extending deposit guarantees, governments need to set adequate
floors and coordinate policies to avoid "beggar-thy-neighbour" policies, while guarding
against the long-run moral hazard effects that will make the regulators' job harder in the
future.

Developing countries that enter the crisis with large balance-of-payments and fiscal deficits
will be the most vulnerable to these effects. Such countries will have larger financing and
adjustment needs, if the current account swings sharply from deficit to balance as capital
dries up, as occurred in the Asian financial crisis. This will put a deep strain on the balance
sheets of domestic firms and banks, potentially leading to a cascade of bankruptcies and bank
failures. If their fiscal resources are already strained to the limit, then it may be impossible to
mount domestically financed rescues of their financial sectors. These countries will likely
have to seek financing for the international financial institutions, especially at a time when
bilateral donors are already straining to meet domestic crisis needs.

More generally, developing-country governments have two main macroeconomic tools for
responding to the negative shock that is coming their way: monetary policy and fiscal policy.
One great risk is that if the credit crisis is not effectively resolved, the global economy could
enter a period of deflation like the one that Japan suffered through in the 1990s. In that
environment, standard monetary policy will not likely be effective in the developed
economies.

Firms in these countries are already on or near the global technological frontier, so there is
limited room for industrial upgrading, meaning that any credit-financed expansion would
primarily be in terms of production capacity. But in the face of low demand and excess

20
capacity, developed country firms are not likely to want or be able to borrow to finance
expansion.

In the developing world, by contrast, there is more room for credit-financed industrial
upgrading, which may give more room for monetary policy to work in those countries that
can afford to use it. Not all countries will be able to; some may find themselves forced to
tighten monetary policy and increase interest rates to prevent excessive currency depreciation
or capital outflows.

On the fiscal-policy side, developing-country governments have a variety of tools that they
could use to cushion the blow of the shock. Governments with some fiscal space can respond
by injecting some well-designed fiscal stimulus into their economies, to generate domestic
demand that can offset the expected decline in foreign demand. Developing countries have
pressing needs that can be met through public investments. One such need is building of
infrastructure, especially after a period when private-sector growth has sometimes outstripped
the ability of the public sector to provide the infrastructure needed to sustain that growth and
rural infrastructure where the infrastructural gap exists between urban and rural areas.

A second area for investment is social protection and human development, to ensure that a
temporary shock is not converted into severe permanent declines in welfare of poorer
households. There are many programmes that have been shown in evaluations to be worth
investing in; governments should prioritize protection and expansion of those that most
effectively buffer the impact of crises on the poorest households.

Developed countries

In the short time since the financial crisis went global, a great deal has already been written
about how developed countries should respond to the global credit crisis. A preponderance of
expert opinion soon formed around core recommendations – that governments recapitalize
banks and provide further guarantees on bank deposits and loans that have already become
policy in the European Union and the United States. Given the brainpower that is already
devoted to the developed-country response, I have focused my recommendations primarily on
developing economies and IFIs.

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So many developing countries have gone through recent financial crises of their own –
including the global debt crisis of the 1980s, the "tequila crisis" of the mid-1990s, and the
Asian financial crisis of 1997/98 (which quickly spread to other emerging markets) – that the
development literature includes some valuable lessons about how to resolve them.

One such lesson concerns the importance of rapidly reaching social consensus on how losses
are to be shared. Without such an agreement, the economy can become mired in social
conflict and prevented from moving forward with reform.

A second set of recommendations concerns developed-country policies that may directly

affect the developing world's ability to respond to crisis. Given the likely economic costs of
the crisis and the certain immediate fiscal costs of the public sector response, governments
will likely feel pressure from taxpayers and voters to raise trade barriers and possibly reduce
international aid. But giving in to those pressures would exacerbate the pressures on the
developing world and risk contributing to a vicious cycle. Resisting protectionist pressures
will be particularly important, after a period during which the developing world sharply
expanded its interdependence with the global economy.

Lessons drawn from study:

1. While every case study country is affected by the crisis in some way, the impact
varies from marginal changes to major damage. Developing countries have not been
shielded from the crisis, and have seen an additional 50 to 100 million people falling
into poverty. While the effects may be manageable, our calculations on the basis of
recent International Monetary Fund (IMF) data and forecasts, suggest that GDP in
sub-Saharan African alone will have fallen 7% ($84 billion) by the end of 2010
compared with pre-crisis forecasts.  
2. The crisis has exposed two myths on financial flows. First, that developing economies
were not integrated into global economic and financial systems. In fact, banking and
stock market collapses did carry the crisis into the developing world. Second, that FDI
is always resilient in a crisis. As the ODI study has found, FDI fell significantly.  
3. Economic and financial openness has led to increased exposure to shocks but this not
always meant increased vulnerability. Bolivia and Tanzania, for example, have
become more resilient through good macroeconomic management, including using
mineral resources to build up reserves, and resilience. 

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 4. Protectionism did not really affect the case study countries, and trade finance was not
seen as a binding constraint to trade, contrary to statements made early in the crisis. 
5. Flexible institutions proved their worth. Task forces in Bangladesh, Mauritius and
Tanzania, for example, generated effective policy responses. 
6. Policy responses in many country case studies were well designed, using fiscal,
financial and monetary policies to address economic management and there were no
major policy reversals. In fact, so-called ‘doing business’ reforms continued.

Taken together, the findings and lessons drawn from the study confirm that countries need to
promote crisis-resilient growth, if they are to be better prepared for shocks in the future.
Good macroeconomic management today means better policy responses tomorrow, if and
when disaster strikes.

But resilience is about more than good macro-economic management. It includes promoting
responsive institutions and pursuing active policies towards diversification. Diversification is
important for both growth and resilience and should be promoted in a market-friendly way so
that policies are not detached from private sector needs. Diversification in sources of capital
flows, such as FDI inflows, has also provided a cushion. Chinese FDI, for example, is now
making up for some of the mining losses in Zambia – a reminder of the importance of links
between emerging markets and low-income countries. Whilst the rise of emerging markets
has offered new opportunities to low income countries, it is not without risks: emerging
markets compete in light manufacturing (as the Bangladesh study highlighted) which poses
new challenges for medium-term growth strategies over and above the need to promote crisis
resilient growth.

FINANCIAL LIBERALISATION IN DEVELOPING COUNTRIES:

Developing countries are no strangers to financial crises, which have marked the history of
some regions such as Latin America for more than a century (Eichengreen 1991) but became
particularly prevalent since the early 1980s. The proclivity to crisis and to financial boom-
bust cycles was especially evident in more financially open and deregulated developing
economies. It is now well known that financial liberalisation has resulted in an increase in
financial fragility in developing countries, making them prone to periodic financial and
currency crises. Internal banking and related crises, and currency crises stemming from more

23
open capital accounts. Greater freedom to invest, including in sensitive sectors such as real
estate and stock markets, ability to increase exposure to particular sectors and individual
clients and increased regulatory forbearance all lead to increased instances of financial
failure. In addition, the emergence of universal banks or financial supermarkets increases the
degree of entanglement of different agents within the financial system and increases the
domino effects of individual financial failures. Indeed, the major financial crises of the recent
past in the developing world – the 1982 Latin American debt crisis, the 1994 Mexican crisis,
the Southeast Asian financial crisis of 1997-98, the 2001 Argentine crisis - can be described
as endogenous market failures resulting from under-regulated and excessively liquid financial
markets (Palma 1998).
In addition, open capital accounts generate tendencies whereby capital
movements occur because of unpredictable changes in investor confidence (Ghosh and
Chandrasekhar 2008). This affects both inflows and outflows in ways that the governments
concerned cannot control. One very common conclusion that has been constantly repeated
since the start of the Asian crisis in mid 1997 is the importance of “sound” macroeconomic
policies, once financial flows have been liberalised. It has been suggested that many
emerging markets have faced problems because they allowed their current account deficits to
become too large, reflecting too great an excess of private domestic investment over private
savings. This belated realisation is a change from the earlier obsession with government fiscal
deficits as the only macroeconomic imbalance worth caring about, but it still misses the basic
point. With unregulated capital flows, it is not possible for a country to control the amount of
capital inflow or outflow, and both movements can create consequences which are
undesirable. If, for example, a country is suddenly chosen as a preferred site for foreign
portfolio investment, it can lead to huge inflows which in turn cause the currency to
appreciate, thus encouraging investment in non-tradeables rather than tradeables, and altering
domestic relative prices and therefore incentives. Simultaneously, unless the inflows of
capital are simply (and wastefully) stored up in the form of accumulated foreign exchange
reserves, they must necessarily be associated with current account deficits. Thus, it was no
accident that all the emerging market economies that received substantial financial capital
inflows also experienced property and real estate booms, as well as stock market booms
around the same time, even while the real economy may have been stagnating or even
declining. These booms, in turn, generated the incomes to keep domestic demand and growth
in certain sectors growing at relatively high rates. This soon resulted in signs of

24
macroeconomic imbalance, not in the form of rising fiscal deficits of the government, but a
current account deficit reflecting the consequences of debt-financed private profligacy.
Large current deficits are therefore necessary by-products of the surge in capital inflow, and
that is the basic macroeconomic problem. This means that any country which does not
exercise some sort of control or moderation over private capital inflows can be subject to
very similar pressures. These then create the conditions for their own eventual reversal, when
the current account deficits are suddenly perceived to be too large or unsustainable. What all
this means is that once there are completely free capital flows and completely open access to
external borrowing by private domestic agents, there can be no “prudent” macroeconomic
policy; the overall domestic balances or imbalances will change according to the behaviour of
capital flows, which will themselves respond to the economic dynamics that they have set
into motion. This knowledge is at least partly responsible for the paradoxical tendency of
developing countries across the globe to hold excess reserves, even when they reflect capital
inflow, rather than use such resources to increase domestic absorption. This strategy of
increasing reserves not only builds a cushion against capital flight in the event of a change in
investor confidence, but also prevents the currency from appreciating. But it creates the
bizarre global result of financial liberalisation, that poor countries end up financing the
expansion and consumption of the richest economies, especially the US, rather than investing
in their own development. That is why the current liberalised system did not provide for a net
transfer of resources to the developing world. In the past six years, there has been a net flow
of financial resources from every developing region to the North, primarily the US, even as
global income disparities have increased.
In addition to creating the conditions for greater internal and external fragility, financial
liberalisation has generated a bias towards deflationary macroeconomic policies in
developing countries. To begin with, the need to attract internationally mobile capital means
that there are limits to the possibilities of enhancing taxation, especially on capital. Typically,
prior or simultaneous trade liberalisation already reduces indirect tax revenues, and so tax-
GDP ratios deteriorate further. This then imposes limits on government spending, since
finance capital is generally opposed to large fiscal deficits and fear of capital flight will
restrict governments from running deficits in such a context. This not only affects the
possibilities for countercyclical macroeconomic stances of the state but also reduces the
developmental or growth-oriented government.
activities of the

25
Such a tendency is exacerbated by the fact that financial deregulation can lead to the
dismantling of the financial structures that are crucial for growth and development
(Chandrasekhar 2008a). While the relationship between financial structure, financial growth
and overall economic development is complex, the basic issue of financing for development
is really a question of mobilising or creating real resources. In the old development literature,
finance in the sense of money or financial assets came in only when looking at the ability of
the state to tax away a part of the surplus to finance its development expenditures, and the
obstacles to deficit-financed spending, given the possible inflationary consequences if real
constraints to growth were not overcome. By and large, the financial sector was seen as
adjusting to the requirements of the real sector. But this need not happen when the financial
sector is unregulated or covered by a minimum of regulation, since market signals then
determine the allocation of investible resources and therefore the demand for and the
allocation of savings intermediated by financial enterprises. This aggravates the inherent
tendency in markets to direct credit to non-priority and import-intensive but more profitable
sectors, to concentrate investible funds in the hands of a few large players and to direct
savings to already well-developed centres of economic activity. The socially necessary role
of financial intermediation therefore becomes muted. This certainly affects employment-
intensive sectors such as agriculture and small-scale enterprises, where the transaction costs
of lending tend to be high, risks are many and collateral not easy to ensure. The agrarian
crisis in most parts of the developing world is at least partly, and often substantially, related
to the decline in the access of peasant farmers to institutional finance, which is the direct
result of financial liberalization (Patnaik 2005). Measures which have reduced directed credit
towards farmers and small producers have contributed to rising costs, greater difficulty of
accessing necessary working capital for cultivation and other activities, and reduced the
economic viability of cultivation, thereby adding directly to rural distress. In India, for
example, there is strong evidence that the deep crisis of the cultivating community, which has
been associated with to a proliferation of farmers’ suicides and other evidence of distress
such as mass migrations and even hunger deaths in different parts of rural India, has been
related to the decline of institutional credit, which has forced farmers to turn to private
moneylenders and involved them once more in interlinked transactions to their substantial
detriment (Ramachandran and Swaminathan 2005).
It also has a negative impact on any medium term strategy of ensuring growth in particular
sectors through directed credit, which has been the basis for the industrialisation process

26
through much of the 20th century. Indeed, it is hard to think of any country that has reached
“developed” status without relying to greater or lesser extent on directed credit. For late
industrialisers, the necessity is even more evident, because capital requirements for entry in
most areas are high; because technology for factory production has evolved in a capital-
intensive direction from its primitive industrial revolution level; because of competition from
established producers within and outside the country.

THE IMPACT OF THE CURRENT CRISIS ON THE DEVELOPING WORLD

The past months 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, in a manner
reminiscent of the behaviour of stock indices in the last major international financial
upheaval in 1929/30 – the Great Depression. The credit crunch and freezing of interbank
lending have been only too evident even in developing countries whose economic
“fundamentals” were apparently strong and whose policy makers believed that they could de-
couple from the global trends.
This almost immediate diffusion of bad news is partly the result of financial liberalisation
policies across the developing world that have made capital markets much more integrated
directly through mobile capital flows, and created newer and similar forms of financial
fragility almost everywhere (Akyuz 2008). 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

27
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 6 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 is already strongly 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

28
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. All the loose talk of China emerging as the
alternative engine of growth for the world economy has died down after China’s exports
contracted in the last two months of 2008 and domestic manufacturing stagnated. 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. Even if China’s policy makers respond by shifting to an
emphasis on the domestic economy, for example through expansionary fiscal policy of along
the lines suggested by the declared fiscal stimulus of $340 billion over two years, 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.
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. For
example, world oil prices, which had increased to nearly $150 per barrel in early July, fell to
less than $40 per barrel by December 2008. (Brent Crude futures) fell to less than $70 per
barrel from nearly $150 in early July. One important index of commodity prices, the Reuters-

29
Jefferies CRB index, in early December was more than 5o 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 or stagnate at low levels for
some time 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 the food crisis 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. 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. And retail prices of food have hardly declined in
most developing countries. 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.
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. 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. The
developing 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, which still has a nationalised banking system and greater degree of regulation,
is better off than Indonesia, but recent reforms that the NDA and UPA government have
pushed through despite Left protests, along with the growing current account deficit, have
rendered the Indian economy more fragile and potentially vulnerable than China.
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

30
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. Large bailouts and the planned
Obama fiscal stimulus in the US will lead to a big increased in the US public debt. It will also
make it harder for the US to maintain its military dominance, which has been a major source
of the strength of the US dollar.
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. 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. 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 as fraudulent. And so this pervasive financial crisis, which is still to fully
play out and work through in real economies, may have create 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.

INTERNATIONAL FINANCIAL ARCHITECTURE AND THE ROLE OF THE IMF

Progressive change will require fundamental changes in the system of organising global
finance and the institutions that govern trade and finance. But such changes will not come
easily. 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.

31
The role of the IMF has once more assumed significance in this changed context. It has been
some time now since the IMF lost its intellectual credibility, especially in the developing
world. Its policy prescriptions were widely perceived to be rigid and unimaginative, applying
a uniform approach to very different economies and contexts. They were also completely
outdated even in theoretical terms, based on economic models and principles that have been
refuted not only by more sophisticated heterodox analyses but also by further developments
within neoclassical theory.
What may have been more damning was how out of sync the policies proposed by the IMF
have also been with the reality of economic processes in developing countries. The 1990s and
early 2000s were particularly bad for the organisation in that respect: their economists and
policy advisers got practically everything wrong in all the emerging market crises they were
called upon to deal with, from Thailand and South Korea to Turkey to Argentina. In
situations in which the crisis had been caused by private profligacy they called for larger
fiscal surpluses; faced with crisis-induced asset deflation they emphasised high interest rates
and tight money policies; to address downward economic spirals they demanded fiscal
contraction through reductions in public spending. The countries that recovered clearly did so
despite their advice, or in several cases because they actively pursued different policies. And
the recognition became widespread among governments in the developing world that IMF
loans were too expensive because of the terrible policy conditions that came with them. So
returning IMF loans early became something of a fashion, led by some Latin American
countries.
In the past few years an even more terrible fate had befallen the IMF: that of increasing
irrelevance. From 2002 onwards, the IMF and the World Bank became net recipients of funds
from developing countries, as repayments far exceeded fresh loans. The developing world
turned its attention to dealing with private debt and bond markets, which is where the action
was. Less developed countries found new sources of aid finance and private investment from
other sources, as China, Southeast Asia and even India to a limited extent, began investing in
other developing countries. So the IMF was not really a significant player in the international
economic scene in the recent past, and the reasons for its very existence were often called
into question. However, every crisis is also an opportunity, and the IMF has been quick to
seize on the current global financial crisis as an opportunity to increase its own influence, by
offering its services to emerging markets. As the crisis spreads and engulfs developing
countries, and as global credit markets seize up and create credit crunches, more and more

32
developing and transition countries are going to need access to emergency liquidity. Already
several countries have lined up for this and signed agreements with the IMF: Pakistan,
Ukraine, Hungary, Iceland. Some European governments have called for a strengthening of
the IMF and even implored surplus countries like China to put more money into the IMF’s
coffers.
But with its current personnel and ideological framework, such strengthening of the IMF will
only mean that the conditionalities it imposes will make things much worse for the
developing world. The guiding principles of IMF lending are clear: countries in the midst of
financial crisis must undergo fiscal contraction, however painful and regardless of whether
the crisis was caused by public or private overspending. When the government account is in
deficit, it must be reduced or converted into a surplus: when it is already in surplus, that
surplus must be increased. This is obviously pro-cyclical and can cause the crisis to spread to
the real economy and create a sharp economic downswing, but this is essential medicine and
necessary pain to ensure the eventual recovery. Acceptance of these principles explains why
so many developing countries have experienced even sharper and more prolonged economic
downturns after turning to the IMF.
However, this argument is apparently valid only for developing economies, whose place is
low in the international financial pecking order. In the World Economic Outlook for October
2008, the IMF clearly exposes very blatant double standards for industrial and developing
countries. Contrary to its past prescriptions, countercyclical macroeconomic policy is seen to
be acceptable for industrial countries. “Macroeconomic policies in the advanced economies
should aim at supporting activity, thus helping to break the negative feedback loop between
real and financial conditions, while not losing sight of inflation risks...Discretionary fiscal
stimulus can provide support to growth in the event that downside risks materialise, provided
the stimulus is delivered in a timely manner, is well targeted, and does not undermine fiscal
sustainability.” (IMF 2008:34, emphasis added.) But for developing countries, who have this
time been caught in a crisis that is not of their own making, the same advice is not tenable at
all. “While emerging economies have greater scope than in the past to use countercyclical
fiscal policy should their economic outlook deteriorate ...this is unlikely to be effective unless
confidence in sustainability has been firmly established and measures are timely and well
targeted. More broadly, general food and fuel subsidies have become increasingly costly and
are inherently inefficient.” In fact, the IMF believes that in developing countries, despite the
economic slowdown, there is room for tightening on all fronts, both fiscal and monetary!
“Greater restraint on spending growth, including public sector wage increases, would

33
complement tighter monetary policy, in the face of rising inflation, which is particularly
important in economies with inflexible exchange regimes.” (IMF 2008: 38)
So the IMF seems to have one rule for industrial countries in crisis, no matter how
irresponsible the run-up to the crisis; and another rule for developing countries, even the most
prudent and fiscally “disciplined” of them. Given this clearly unbalanced and potentially
disastrous approach of the IMF, the need to examine alternative and less destructive sources
of emergency finance for crisis-affected developing countries is urgent, as is the need, over
the medium-term, to create a more democratic and less rigid international financial regime.

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THE CRISIS AND INDIA :
When the crisis first broke internationally, within India there was much talk of how the
Indian economy is less likely to be affected and how the Indian financial sector will be
relatively immune to the winds from the international financial implosion. But it is clear that
important elements of the balance of payments and the domestic financial sector have been
affected. There are significant implications for domestic banking, which are already reflected
in the credit crunch that has dramatically affected access to credit especially for small and
medium enterprises. There are effects on some important macroeconomic prices – in
particular the exchange rate. And there are direct and indirect effects on employment, with
falling export employment generating negative multiplier effects.
Despite all this, Indian policy makers still seem to be caught in some complacent time-warp,
whereby they proudly point to the GDP growth rate (now spluttering, but still high by
international standards) and to the supposed “resilience” of the domestic financial sector. Of
course, neither of these is as positive as the government would like to make out. The current
slowdown in GDP is sharper than the government would like to admit, and more significantly
it has been accompanied by a much steeper than expected reduction in employment,
especially in export sectors. Domestic banking is still generally secure, especially because
nationalised banking remains the core of the system, largely thanks to resistance from the
Left parties to government attempts to privatise it. Even so, there are clear signs of fragility
and inadequacy within the banking sector: the recent rapid growth of often dodgy retail
credit, associated attempts to securitise such debt, the emergence of a credit crunch in the
face of macroeconomic uncertainty, and the inability or unwillingness of the banking system
to provide loans to medium and small borrowers other than in the form of personal credit.
Beyond these implications, the effects of the global crisis have directly impacted upon some
important macroeconomic variables. Three such indicators stand out in terms of their quite
sudden deterioration since the middle of last year: the decline in the foreign exchange
reserves held by the Reserve Bank of India; the fall in the external value of the rupee,
especially vis-à-vis the US dollar; and the decline in stock market indices.
Chart 1 shows how foreign exchange reserves, which had been increasingly steadily over the
past few years, started declining after June 2008. It must be noted that the earlier build-up of
reserves did not reflect any real macroeconomic strength, since unlike China it was not based
on current account surpluses. Instead, the Indian economy experienced an inflow of hot
money, especially in the form of portfolio capital of FII investment. Domestic macro policies

35
combined with the need to prevent exchange rate appreciation to prevent increased domestic
absorption of such resources, as a result of which these were largely added to reserves. Since
they were based on hot money inflows, it was only to be expected that they would reverse
with any bad news, and that is essentially what has happened over the past eight months, with
the bad news coming from the US and other developed markets rather than from the Indian
economy. This movement of foreign institutional investors was in turn related to the sudden
collapse of the rupee, shown in Chart 2. Early in March 2009 the rupee even breached the
line of Rs 51 per dollar, and currently continues to fall. There are those who argue that this
depreciation is positive since it will help exports, but conditions prevailing in the world trade
market, with falling export volumes and values, does not give rise to much optimism in that
context. India currently has a current account deficit including a large trade deficit and also
quite significant factor payments abroad. The falling rupee implies rising factor payments
(such as debt repayment and profit repatriation) in rupee terms, which has adverse
implications for many companies and for the balance of payments.
Associated with all this is the evidence of falling business confidence expressed in the stock
market indicators. The Sensex, shown in Chart 3, had reached historically high levels in the
early part of 2008, capping an almost hysterical rise over the previous three years in which it
more than tripled in value. But it has plummeted since then, with high volatility around an
overall declining trend, such that its levels in early March were below the levels attained in
December 2005.
How much of all this is due to the behaviour of foreign investors, rather than domestic
investors? Chart 4 tracks the changes in total foreign investment, split up into direct
investment and portfolio investment, over the period since April 2007. It is evident that both
have shown a trend of increase followed by decline. FDI has been more stable with relatively
moderate fluctuations (even though it does include some portfolio-type investments that get
categorised as foreign direct investment). It peaked in February 2008 and thereafter has been
coming down but is still positive. Portfolio investment (which includes both FII investment in
the domestic share market and GDRs/ADRs) has been extremely volatile and largely negative
(indicating net outflows) since the beginning of 2008, and this has dominated the overall
foreign investment trend.
As a result, as Chart 5 shows, the cumulative value of the stock of Indian equity held by FIIs
fell quite sharply, by 24 per cent between May 2008 and February 2009. This is not likely to
be due to any dramatically changed investor perceptions of the Indian economy, since if
anything GDP growth prospects in India remain somewhat higher than in most other

36
developed or emerging markets. Rather, it is because portfolio investors have been
repatriating capital back to the US and other Northern markets. This reflects not so much a
flight to safety (for clearly US securities are not that safe anymore either) as the need to cover
losses that have been incurred in sub-prime mortgages and other asset markets in the North,
and to ensure liquidity for transactions as the credit crunch began to bite. Whatever the
causes, the impact on the domestic stock market has been sharp and direct. Since the Indian
stock market is still relatively shallow, and FII activities play a disproportionately strong role
in determing the movement of the indices, it is not surprising that this outward flow has been
assocated with the overall decline in stock market valuations. As Chart 6 shows, the Sensex
has moved generally in the same direction as net FII inflows. In fact movements in the latter
have been much sharper and more volatile, suggesting that domestic investors have played a
more stabilisng role over this period.
Overall foreign investment flows (including not just FII but direct investment) have also,
predictably, played a role in determining the level of external reserves. Once again the two
move together. In this case, however, foreign investment has been less volatile than the
change in reserves, suggesting that other components of the balance of payments have been
important as well. The changes in external commercial borrowing are likely to have been
significant.
In addition, the possibilities of domestic investors moving their funds out should not be
underestimated. the recently liberalised rules for capital outflow by domestic residents have
led to outflows that are not insignificant, even if still relatively small. Liberalised rules for
capital account transactions by Indian residents seem to be increasing the vulnerability that
derives from India’s dependence on foreign investment flows. This an aspect of India’s
external payments that policy must address, especially since there are constraints set by WTO
membership on using tariffs and quantitative restrictions on reducing foreign exchange
outflows that occur on account of imports.

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CHAPTER 6:

CONCLUSION:

The current financial crisis affects developing countries in two possible ways:
First, there could be financial contagion and spillovers for stock markets in emerging
markets. The Russian stock market had to stop trading twice; the India stock market dropped
by 8% in one day at the same time as stock markets in the USA and Brazil plunged. Stock
markets across the world – developed and developing – have all dropped substantially since
May 2008. We have seen share prices tumble between 12 and 19% in the USA, UK and
Japan in just one week, while the MSCI emerging market index fell 23%. This includes stock
markets in Brazil, South Africa, India and China. We need to better understand the nature of
the financial linkages, how they occur (as they do appear to occur) and whether anything can
be done to minimise contagion.
Second, the economic downturn in developed countries may also have significant impact on
developing countries. The channels of impact on developing countries include:
• Trade and trade prices. Growth in China and India has increased imports and pushed up
the demand for copper, oil and other natural resources, which has led to greater exports and
higher prices, including from African countries. Eventually, growth in China and India is
likely to slow down, which will have knock on effects on other poorer countries.
• Remittances. Remittances to developing countries will decline. There will be fewer
economic migrants coming to developed countries when they are in a recession, so fewer
remittances and also probably lower volumes of remittances per migrant.
• Foreign direct investment (FDI) and equity investment. These will come under pressure.
While 2007 was a record year for FDI to developing countries, equity finance is under
pressure and corporate and project finance is already weakening. The proposed Xstrata
takeover of a South African mining conglomerate was put on hold as the financing was
harder due to the credit crunch. There are several other examples e.g. in India.
• Commercial lending. Banks under pressure in developed countries may not be able to lend
as much as they have done in the past. Investors are, increasingly, factoring in the risk of
some emerging market countries defaulting on their debt, following the financial collapse
of Iceland. This would limit investment in such countries as Argentina, Iceland, Pakistan
and Ukraine.
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• Aid. Aid budgets are under pressure because of debt problems and weak fiscal positions,
e.g. in the UK and other European countries and in the USA. While the promises of
increased aid at the Gleneagles summit in 2005 were already off track just three years later,
aid budgets are now likely to be under increased pressure.
• Other official flows. Capital adequacy ratios of development finance institutions will be
under pressure. However these have been relatively high recently, so there is scope for
taking on more risks.

Each of these channels needs to be monitored, as changes in these variables have direct
consequences for growth and development (see e.g. Te Velde, 2008, on pro-poor
globalisation). Those countries that have done well by participating in the global economy
may also lose out most, depending on policy responses, and this is not the time to reject
globalisation but to better understand how to regulate and manage the globalisation processes
for the benefit of developing countries. The impact on developing countries will vary. It will
depend on the response in developed countries to the financial crisis and the slowdown, and
the economic characteristics and policy responses, in developing countries.

Some of the countries that are at risk are as follows:

The list of channels above suggest that the following types of countries are most likely to be
at risk (this is a selection of indicators):
• Countries with significant exports to crisis affected countries such as the USA and EU
countries (either directly or indirectly). Mexico is a good example;
• Countries exporting products whose prices are affected or products with high income
elasticities. Zambia would eventually be hit by lower copper prices, and the tourism sector
in Caribbean and African countries will be hit;
• Countries dependent on remittances. With fewer would eventually be hit by lower copper
prices, and the tourism sector in Caribbean and African countries will be hit;
• Countries dependent on remittances. With fewer bonuses, Indian workers in the city of
London, for example, will have less to remit. There will be fewer migrants coming into the
UK and other developed countries, where attitudes might harden and job opportunities
become more scarce;

39
 • Countries heavily dependent on FDI, portfolio and DFI finance to address their current
account problems (e.g. South Africa cannot afford to reduce its interest rate, and it has
already missed some important FDI deals);
• Countries with sophisticated stock markets and banking sectors with weakly regulated
markets for securities;
• Countries with a high current account deficit with pressures on exchange rates and
inflation rates. South Africa cannot afford to reduce interest rates as it needs to attract
investment to address its current account deficit. India has seen a devaluation as well as
high inflation. Import values in other countries have already weakened the current account;
• Countries with high government deficits. For example, India has a weak fiscal position
which means that they cannot put schemes in place;
• Countries dependent on aid.
While the effects will vary from country to country, the economic impacts could include:
• Weaker export revenues;
• Further pressures on current accounts and balance of payment;
• Lower investment and growth rates;
• Lost employment.
There could also be social effects:
• Lower growth translating into higher poverty;
• More crime, weaker health systems and even more difficulties meeting the Millennium
Development Goals.

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CHAPTER 7:

BIALIOGRAPHY:

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