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speak up!
The financial crisis and the developing world
AN INTERVIEW WITH JOMO KWAME SUNDARAM, THE
ASSISTANT SECRETARY-GENERAL FOR ECONOMIC
DEVELOPMENT FOR THE UNITED NATIONS DEPARTMENT
OF ECONOMIC AND SOCIAL AFFAIRS.
QUESTION: The stock markets in
developing countries — the “emerg-
ing markets” — are tumbling. What
are the consequences for ordinary
people? Does it matter?
JOMO: So far, stock markets in
emerging economies have plunged by
about 50% on average, some by more
than 60% (China, Russia, for example)
– much more than the average drop of
about 30% in the rich countries.
It does matter to ordinary people.
In most emerging markets, not only
rich people, but many middle income
households own equities. The losses in
equity markets will have direct impact
on their income and wealth.
For the poor, who don’t own any
stocks, the indirect impact may also
be significant: As stock markets plum-
met, the solvency of banks and firms
depend on how much capital they own.
If the value of their capital plunges,
even solvent firms will suddenly look
overleveraged and face problems.
Banks are trying to shore up their
capital positions and many have
stopped lending. This leads firms to cut
investment spending and use remain-
ing earnings to cover operational costs,
which may lead them to start laying
off workers.
The drop in stock market prices is
part of a downward spiral which will
cause the world economy to slow
down, causing increased unemploy-
ment and worsening work conditions.
That will also affect government
revenue and further limit the scope
for government spending on social
services and transfers to the poor.
So, the overall impact will be felt by
all. Much will depend on how govern-
ments respond with counter-cyclical
and social protection policies, and
following the economic liberalisation
of recent decades, the latter is unlikely
to be a major policy priority.
Is there a rational explanation for
why international financial capital
is pulling out from developing
countries?
Yes, there are a few explanations. When
there is a global crisis, international
investors (pension funds, mutual funds
and hedge funds) become more risk
averse, reducing exposure to emerging
markets, which are considered to be
riskier than other investments (such as
the US Treasury notes).
Some international institutional
investors are forced to withdraw by
“margin calls” at home: their losses in
developed country markets force them
to withdraw some of their investments
from emerging markets.
More fundamentally, the global
crisis will seriously weaken growth
worldwide. As a consequence, earnings
in emerging markets will fall, reducing
investor interest in emerging market
stock.
In light of the financial crisis, what
trends do you expect to see in foreign
direct investment (FDI) in develop-
ing countries in the next one to two
years? What impact will this have
on developing country economies?
FDI inflows to emerging markets tend to
be more stable than short-term equity
investments and other portfolio flows.
Nonetheless, the global financial crisis
will also affect FDI inflows negatively.
With the total supply of funding avail-
able in developed countries tightening,
financial crisis and global recession will
reduce investments, including invest-
ments abroad. UNCTAD’s latest World
Investment Report expects a 10% drop
of FDI to emerging markets in 2008
compared to 2007. With the slowdown,
FDI will slow further in 2009.
Shrinking economies in the US and
other rich countries seem certain
to shrink export opportunities for
developing countries. How will this
affect them, and how do you sug-
gest they adjust? Are there lessons
about relying so heavily on exports
to drive economic development?
Fifty percent of US imports are from
developing countries. So, shrinking
demand in rich countries will have sig-
nificant impacts on developing coun-
tries. In fact, a slowdown in exports
of developing countries, particularly
in Asia, is likely to lead to a significant
slowdown in industrial production,
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as well as GDP, in many developing
countries. In Latin America and Africa,
export growth has mainly been driven
by primary commodities.
Various issues of the UN’s World
Economic and Social Survey have reit-
erated the risks of heavy dependence
on exports which do not have strong
linkages with the domestic economy,
particularly primary commodities. Such
economies tend to be vulnerable to
external shocks.
High commodity prices, responsible
for the last half-decade of rapid growth
in many developing countries, have
begun to decline in the last half-year,
with the price of oil dropping by almost
70% in the last four months.
In the short run, developing
countries should stimulate domestic
demand, so as to offset weakening
foreign demand, as China has been do-
ing. For the poorer countries, the scope
for doing so is more limited; they may
need more foreign aid to cope with
the drops in export earnings because
of weakening commodity prices and
global recession.
In the long run, however, they need
to engage in active investment and
technology policies to diversify their
economies and reduce dependence
on commodity exports.
What lessons does the financial
crisis hold for proponents of fi-
nancial liberalisation in developing
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countries? Do you think pressures
for financial liberalisation will abate
— and if so, for how long?
Earlier pressures for financial liberalisa-
tion will likely abate, though it is not
clear for how long. Calls for more regu-
lation and government intervention are
typical responses during crises, but
once the crisis subsides, the pressure
to reform may be lost. This crisis – like
the financial crises of the 1980s and
1990s, which mainly affected emerg-
ing market economies – shows that
financial deregulation has gone too far.
Quick fixes during a crisis do not offer
adequate solutions preventing crises
from emerging again.
For developing countries, at least three
things are important.
First, affordable financing should
be available for productive long-term
investments not disrupted during
downturns. Development banks can
help ensure long-term, large-scale
investments which rely heavily on gov-
ernment resources. Commercial banks
should also have incentives to support
productive investments. Deeper finan-
cial markets, especially bond markets,
can also play useful roles in emerging
market economies.
Second, financial regulation should
be strengthened. Existing approaches
to regulation should be appropriate
to new conditions and challenges.
Now, in most countries, banks have
to increase provisioning against bad
loans after they encounter problems.
Such requirements are pro-cyclical,
tightening credit when it is needed
most. Regulatory frameworks need to
be counter-cyclical, in this case, build-
ing capital reserves during good times
to provide resilience for bad times.
Third, countries should have ap-
propriate capital controls in place to
avoid undesirable and excessive capital
inflows when not needed, and to stem
sudden, disruptive large outflows.
Do you see contradictions between
the massive interventions by the
US government (and increasingly
other rich country governments) in
response to the financial crisis, and
the policies recommended and/or
mandated by the International
Monetary Fund in the 1997-1998
Asian financial crisis and others
focused on developing countries?
Yes. It is obvious. Some of the measures
the US adopts now were those the US
Treasury and the IMF criticised harshly
during the Asian crisis – efforts to force
banks to lend at low interest rates,
bailouts of banks and other financial
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institutions, even restrictions on short-
selling. I have joked that former Prime
Minister Tun Dr Mahathir Mohamad is
the true American Idol, at least for the
US Treasury and Fed today.
Thankfully for the US, the Fed has
a broader mandate than most other
central banks today, which are often
required to focus almost exclusively
on containing inflation, whereas the
Fed is obliged to sustain growth and
employment.
Is there a developing country
perspective that is distinct from
the general commentaries in rich
countries?
Once again, developing countries will
have to bear the brunt of the global
financial crisis originating in the US
and other developed countries. The
financial positions of many developing
countries are much stronger than they
were at the time of the financial crises
in Asia and Latin America, given their
strong foreign reserve positions and
generally better fiscal balances.
Yet, this does not mean these
countries are immune to the crisis as
suggested by those who claim that
the larger developing countries have
“decoupled” from the US economy.
The financial crisis is likely to lead
to a severe and possibly protracted
downturn in the global economy which
will depress commodity prices and
foreign investments once again.
Further, the US dollar is likely to
continue to depreciate. The brief re-
surgence this fall is not likely to last,
given the huge US trade and budget
deficits. As most reserves of develop-
ing countries are held in dollars, those
with strong foreign reserve positions
will incur massive losses.
Nonetheless, those countries with
massive trade surpluses will continue
to buy US Treasury notes for various
reasons, thus continuing to finance
the likely rise in the US fiscal deficit to
finance the bailouts as well as fiscal
and other counter-cyclical measures.
Jomo K.S. was professor in the Applied
Economics Department, University of
Malaya, and founder chair of IDEAs,
or International Development Eco-
nomics Associates. In 2007, he was
awarded the Wassily Leontief Prize for
Advancing the Frontiers of Economic
Thought. In 2008, he was appointed to
the United Nations High-Level Expert
Commission to Study the Reform of the
International Monetary and Financial
System chaired by Nobel laureate
Professor Joseph Stiglitz.