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The Financial Crisis: Implications for Developing Countries

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  • World Bank Group scales up support for crisis
  • Revises outlook for growth in 2009 in both rich and poor countries
  • Focuses on social safety net programs to bail out the world’s poorest
  • Analyzes financial sector stabilization and reform options

Updated November 13, 2008

November 11, 2008—The world economy has changed dramatically since September 2008. What began as a downturn in the US housing sector is now a global crisis, spreading to both rich and poor economies. Many believe that this may go down in history as the worst crisis since the Great Depression of the 1930s.

Developing countries—at first sheltered from the worst elements of the turmoil—are now much more vulnerable, with dwindling capital flows, huge withdrawals of capital leading to losses in equity markets, and skyrocketing interest rates.

GDP growth in developing countries—only recently expected to increase by 6.4 percent in 2009—is now likely to be only 4.5 percent, according to economists at the World Bank. And rich countries are now expected to contract by 0.1 percent next year.

Responding today, securing tomorrow

A World Bank background paper prepared for the G20 meeting of heads of state to be held in Washington DC on November 15th notes that weaker growth, combined with the credit crunch, means that governments will have less money to invest in education, health and women’s empowerment. Read paper 

As a result of high food and fuel prices, it is estimated that 100 million people have already been driven into extreme poverty. With every one percent decline in developing country growth rates, approximately 20 million more people are added to this rapidly swelling number.

The global financial crisis, coming so soon after the food and fuel crises, is likely to hurt the poor most in developing countries,” said World Bank Group President Robert B. Zoellick, “Working with the IMF, UN agencies, and regional development banks and others, the World Bank Group is helping both governments and the private sector through lending, equity investments, innovative new tools, and safety net programs.”

The World Bank Group’s response to this crisis includes increased lending for crisis-hit developing countries—likely to nearly triple from US$13.5 billion last year to more than US$35 billion this year—as well as accelerated grants and virtually interest-free long-term loans to the world’s 78 poorest countries, 39 of which are in Africa.

Besides extending help to cash-strapped governments, the Group is boosting support to the private sector through four initiatives by the International Finance Corporation (IFC), and providing much-needed liquidity in developing country banking markets through the Multilateral Investment Guarantee Agency (MIGA). More 

A revised outlook for developing country growth

Real GDP growth forecast for developing regions
(percentage change from previous year)
East Asia and the Pacific8.86.7
Europe and Central Asia63.5
Latin America & Caribbean4.52.1
Middle East & North Africa5.73.5
South Asia6.35.4
Sub-Saharan Africa5.44.6
A preview of the analysis for this year’s Global Economic Prospects report, to be published December 9, 2008, shows that real GDP growth will slow down across all developing regions in 2009.

The direct impact of the crisis is less dramatic in the financial sectors of the poorest countries,” said Uri Dadush, Director Development Prospects Group, “but they will be hit nevertheless by slower export growth—global trade is expected to decline by 2.5 percent in 2009—reduced remittances by migrant workers; and lower commodity prices that will affect commodity-exporting countries.”

Commenting on the projected decline in world trade, which would be the first such drop since 1982, Mr. Zoellick said, “One of the primary drivers of this is the credit crunch. It's not just the lack of demand for the product, but there's a big gap in trade finance and, it appears, even working capital for some of the shipping firms. So, we at the World Bank had already expanded a trade finance facility that's a pool to $1.5 billion, and we're looking about expanding that.

Preventing the financial crisis from turning into a human one

Like previous crises, this one will hit the poorest people the hardest. Many households, already weakened, are faced with having to sell assets like livestock to survive. Malnutrition could well rise, and school enrollment may well fall. The financial crisis will turn into a human one if the poor are left to fend for themselves.

Economists at the World Bank believe that social safety net programs—particularly those that are well-designed—are a smart investment both for today and the future. These programs are affordable; Mexico’s successful Oportunidades and Brazil’s Bolsa Familia cost just about 0.4 percent of GDP.

Crises have given birth to some of the worst social protection policies, and some of the best,” said Martin Ravallion, Director, Development Research at the World Bank. “Some developing countries, including Mexico, have turned crisis into opportunity by dismantling inefficient subsidies in favor of more efficient safety nets.”

In an October 2008 policy research working paper, “Bailing Out the World’s Poorest,” Ravallion notes that a comprehensive safety net requires a combination of two things—targeted conditional cash (or food) transfers for those who cannot work or should not be taken out of other activities like school, and guaranteed low-wage relief work on community-initiated projects.

Staff of the Bank's Development Research Group note, in a November 2008 paper, "Lessons from World Bank research on financial crises," that the short-term responses to a crisis—macroeconomic stabilization, trade policies, financial sector policies and social protection—cannot ignore longer-term implications for both economic development and vulnerability to future crises.

Stabilizing the financial sector

A new agenda is now emerging for financial sector policymaking,” said Asli Demirguc-Kunt, Senior Research Manager, Finance, in the World Bank’s Development Research Group. “This crisis is prompting a reassessment of certain principles and practices in financial sector policymaking. There could be important changes in the structure and oversight of financial systems worldwide.”

To prevent shifts of deposits to state-owned banks, developing countries may now need to provide some sort of underwriting of banking system deposits, but deposit insurance should be designed carefully because such measures take large scale fiscal resources to be credible and may introduce incentives for excessive borrowing.

A stronger financial system will also require effective collateral registration and enforcement systems, well-functioning payments and settlement systems, and well designed corporate governance structures, says new World Bank policy analysis.

Governments will also need to strike a balance between maintaining financial stability and encouraging financial innovation.

The need to kick-start lending to the real sector once again following the credit squeeze may lead several countries to upgrade the role of development banks and the use of directed lines of credit and credit guarantee schemes, as well as to involve themselves in the resource allocation decisions of recently-nationalized banks. This projection depends on country circumstances.   

It is very important that countries come together to face the crisis in a coordinated way,” said Justin Lin, World Bank Chief Economist, speaking at the Korea Development Institute in Seoul in October 2008. “But whatever the details of the multilateral effort, the point is that the scale of the problem demands greater creativity. We cannot be constrained by institutional structures and approaches designed for a world before financial globalization.”

Read Paper: The Unfolding Crisis

Read Paper: The 2007 Meltdown in Structured Securitization: Searching for Lessons, not Scapegoats 

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