New Delhi, 28 Oct (Jayati Ghosh*) -- It is clear from the past few weeks
that the developing world is far from immune to the financial crisis
originating in the West. Stock prices in emerging markets have gone on
similar roller coaster rides to those in New York and Europe.
Indeed, they have shown such very high volatility, going sharply up and down
on a daily basis around an overall declining trend, that the pattern is
reminiscent of the behaviour of stock indices in 1929/30 at the start of the
Great Depression.
And the credit crunch and freezing of interbank lending have been evident
even in developing countries whose economic "fundamentals" are apparently
strong and whose policy makers believed that they could de-couple from the
global trends.
This diffusion of bad news is the result of financial liberalisation
policies across the developing world that have made capital markets much
more integrated directly through mobile capital flows, as well as created
newer and similar forms of financial fragility almost everywhere.
But the international transmission of turbulence is only one of the ways in
which the global financial crisis can and will affect developing countries.
A medium-term implication is the impact on private capital flows to
developing countries, which are likely to reduce with the credit crunch and
with reduced appetite for risk among investors. The past five years
witnessed an unprecedented increase in gross private capital flows to
developing countries.
Remarkably, however, this was not accompanied by a net transfer of financial
resources, because the developing regions chose to accumulate foreign
exchange reserves.
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 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 this may
be a blessing in disguise as it reduces upward pressure on exchange rates
and creates more emphasis on domestic resource mobilisation.
Similarly, it is also very likely that the crisis will reduce official
development assistance to poor countries. It is well known that foreign aid
is strongly pro-cyclical, in that developed countries' "generosity" to poor
countries is adversely affected by any reversal in their own economic
fortunes. But in any case, development aid has also been experiencing an
overall declining trend over the past two decades, even during the recent
boom.
In fact, the developed countries were extremely miserly even in providing
debt relief to countries whose development prospects have been crippled by
the need to repay large quantities of external debt that rarely contributed
to actual growth.
Notwithstanding the enormous international pressure for debt write-off, the
G-8 countries have provided hardly any real debt relief. When they have done
so, they have provided small amounts of relief along with very heavy and
damaging policy conditionalities and in a blaze of self-serving publicity.
So the speed and extent of the debt relief provided to their own large banks
by the governments of the US and other developed countries, even when these
banks have behaved far more irresponsibly, has not gone unnoticed in the
developing world.
One major source of foreign exchange that will certainly be affected is
remittance incomes, especially from workers based in Northern countries.
Already, the Inter-American Development Bank estimates that 2008 will be the
first year on record during which the real value of inward remittances will
fall in Latin America and the Caribbean.
Remittances into Mexico (which are dominantly from workers based in the US)
in August were already down 12 per cent compared to a year previously, and
this will only get worse. There is also evidence of declining remittances
from other countries that relied strongly on them, such as the Philippines,
Bangladesh, Lebanon, Jordan and Ethiopia. In India, where around half of
inward remittances currently come from the US, the same pattern of decline
is likely.
Exports of goods and services, like remittances, are going to be affected by
the global economic downturn. For most developing countries, the US and the
European Union remain the most important sources of final export demand, and
as they inevitably tip into recession, exports to these markets will also
decline.
There has been much talk of China emerging as the alternative engine of
growth for the world economy. But this is highly unlikely, for several
reasons.
First, Chinese growth, which has pulled along many other Asian developing
countries in a production chain, has been largely export-led. The US, EU and
Japan together account for more than half of China's exports, and as their
economic crisis intensifies, it is bound to affect both exports and economic
activity in China.
Second, even if China's policy makers respond by shifting to an emphasis on
the domestic economy, this is unlikely to generate levels of international
demand that will come anywhere near to the meeting the shortfall created by
recession in the developed countries. China's share of global imports is
still too small for it to serve as a growth engine on the same scale.
Fond hopes have been expressed by some western policy makers and economists,
that China can use the $2 trillion of foreign reserves that it controls
(directly and through Hong Kong SAR) to bail out the bankrupt US financial
system.
But these hopes are also misplaced. It is likely that eventually some of the
shares purchased by the US Fed and Treasury in their troubled banks may be
eventually auctioned off to Chinese and other sovereign wealth funds among
other investors.
But this is not anything like a solution to the basic problem of dealing
with the "toxic assets" held by the various troubled financial institutions
of the West, especially as even the full amount of such assets is still not
known given the complicated entanglement of such institutions.
Across the developing world, one additional detrimental effect of the
current crisis is likely to be the postponement or even cancellation of
large investment projects whose ultimate profitability is now in doubt. This
will have negative multiplier effects, as cancelled orders and lost jobs
further reduce demand.
The construction sector has already been hit, and many large projects are
being cancelled even in economies that are still growing. The aviation
sector is going through a major shakeout, which is evident 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.
The oil price has fallen to $61-63 per barrel from nearly $150 in early
July. One important index of commodity prices, the Reuters-Jefferies CRB
index, on 14 October was 40 per cent below its all-time high in July.
While speculative behaviour was clearly behind the volatility in commodity
prices over the past year, it is likely that such prices will continue to
decline now because of the broader economic slowdown.
This may provide some breathing space in terms of inflation control for
importing developing countries, especially oil importers. But even at $60 a
barrel, oil prices are still far above their nominal level five years ago.
And while world prices of important food items have also declined in the
recent past, they are still too high for many developing countries with low
per capita incomes and a large proportion of already hungry people.
Indeed, the financial crisis may actually make it more difficult for many
governments of poor developing countries to secure adequate commodity
supplies to meet their people's needs. The food crisis seems to have gone
off the international media map, but it still rages for possibly a majority
of the population of the developing world, and the current global economic
crisis will certainly not make it better.
These are forces that will affect all or most developing countries, but they
will be felt differently in different places. In particular, the extent of
financial contagion and possible local financial crisis depends on how far
the developing country concerned has gone along the road of financial
liberalisation.
It is worth noting that those countries that have gone furthest in terms of
deregulating their financial markets along the lines of the US (for example,
Indonesia) have been the worst affected and may well have full blown
financial crises of their own.
By contrast, China, which has still kept most of the banking system under
state control and has not allowed many of the financial "innovations" that
are responsible for the current mess in developed markets, is relatively
safe.
India, which still has a nationalised banking system and greater degree of
regulation, is better off than Indonesia, but reforms initiated by recent
governments as well as the growing current account deficit have rendered the
country more fragile and potentially vulnerable than China.
In addition, countries with large external debts and current account
deficits will face particular problems. Already, it is apparent that
financial markets are estimating the risk of default (in the form of the
price of credit default swaps) for countries such as Pakistan, Argentina and
Ukraine as high as 80 per cent or more.
Sometimes, as in Kazakhstan and Latvia, it is because of their highly
leveraged banking systems. In other cases, as for Turkey and Hungary, it is
because of the very high current account deficits.
Of course, developing countries are still bit players in this global drama.
This particular financial crisis has so many ramifications mainly because it
is occurring in the very core of capitalism, and originated in the US, the
country that had the global power and influence to impose its own economic
model on almost all of the rest of the world.
And the depth and severity of the crisis are likely to signal global
political economy changes that will shape the world for the next few
decades. Geopolitical shifts are likely to result from such glaring exposure
of economic vulnerability in the global hegemon.
While the drama is still being played out and the ultimate denouement is
still unclear, what cannot be denied is that US dominance of world economics
and politics is now under severe question, and has suffered a blow from
which it may not recover.
There was certainly some symbolism in the fact that on the day when a
Chinese man was walking in space for the first time, the US Treasury
Secretary was down on his knees pleading for a bailout.
The changes in the world in the next decade will not be linear or
unidirectional, and there are bound to be savage conflicts over resources
and much else, but the recent pattern of global imperialism has been
severely disturbed.
This is not a conclusion that will be easily drawn in Washington, or even in
Europe. Financial crises were things that happened in the developing world,
after the breaking of which western officials, consultants and others could
lecture the governments of the crisis-ridden countries on their past
profligacy and wrong policies, and proceed to administer the severe
"Washington Consensus" medicine that they felt was essential.
Now, of course, the wrongdoing and the collapse are most evident in the US
and Europe, and they are following the opposite of what they had prescribed
for developing countries, by rescuing banks and going in for Keynesian
counter-cyclical macroeconomic policies.
So it should be difficult, at least for a while, for even the most
hard-boiled and insensitive Western policy adviser to take the same high
moral tone with developing countries as in the past.
The global financial and trading system 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.
The tiny countries of Belgium, Netherlands and Luxembourg, with a total
population of less than 28 million, have more votes in the IMF than China,
Brazil or India.
But even more than the geopolitical or economic shift, a bigger shift may
come about from the clear failure of the economic model of neoliberalism.
The notions that markets know best, and that self-regulation is the best
form of financial regulation, have now been completely exposed for the
frauds that they are.
And so this pervasive financial crisis, which is still to fully play out and
work itself through in real economies, may have led to one very positive
shift. It has created a genuine opportunity not only for questioning the
economic paradigm that has been dominant for far too long, but also
replacing it with more progressive and democratic alternatives.
[* Jayati Ghosh is Professor of Economics at the Jawaharlal Nehru University
and a leading member of the International Development Economics Associates
(IDEAS). This is a slightly edited version of an article published in IDEAS
(www. networkideas. org).] +
