March 7, 2008— With financial markets being in a state of turmoil, developing countries—often vulnerable to shocks from the outside that are beyond their control—are concerned about possible threats to their own macroeconomic stability.

Even as many developing countries show improved resilience to upsets in rich-country financial markets, continuing turbulence—coupled with its dampening effect on world growth—poses a significant risk to developing economies.

Many countries have accumulated large foreign reserves to protect themselves against interest and exchange rate fluctuations, as well as short-term funding disruptions, but reserves are only a temporary solution.

According to World Bank researchers, the best way forward for developing countries is to develop comprehensive strategies to fight macroeconomic volatility on several fronts, including by improving their ability to absorb external shocks.

“Action is warranted because macroeconomic volatility is a fundamental development concern,” said Luis Servén, Research Manager in the Bank’s Development Research Group, “It has much higher welfare costs for poor countries than for rich countries.”

In Latin America, for example, the direct welfare loss of straying away from a stable consumption path reaches up to 10 percent of annual consumption in some countries, compared to less than 1 percent in industrial countries.

Macroeconomic volatility reduces growth in economic output, and affects future consumption, Servén notes. This effect is seen most in poor countries that are financially and institutionally weak, and that are unable to adjust their fiscal policies in response.

The chicken or the egg?

Small countries like the Dominican Republic or Togo experience volatility, but so do large ones such as China and Indonesia. Many volatile economies, for example, Ecuador and Nigeria, are predominantly commodity-exporters, but others like Peru are rapidly industrializing.

“It’s a classic chicken-and-egg question,” said Norman Loayza, Lead Economist in the World Bank’s Development Research Group. “Does volatility result in a lack of development or does underdevelopment reflect itself in macroeconomic fluctuations? ”

Analyzing what puts poor countries at greater risk, Serven, Loayza, Rancière and Ventura say that high macroeconomic volatility in the developing world stems from three sources:

• bigger external shocks, such as from financial and goods markets
• more frequent domestic shocks, including self-inflicted policy mistakes
• weaker “shock absorbers” to cushion the effects of disturbances

Coping with these sources of macroeconomic volatility requires a three-pronged strategy for improving economic stability in developing countries, the researchers argue.

Put the house in order

An unstable development process, coupled with self-inflicted policy mistakes, seems to lead to more frequent domestic shocks in developing countries. In fact, the erratic fiscal policy of governments often triggers macroeconomic volatility. In some instances, governments inadvertently raise volatility through inflationary monetary policy.

“In recent research, we have found that social conflict, political instability, and economic mismanagement are the most likely causes of the fluctuations in per capita GDP in many poor countries,” said Claudio Raddatz, also a World Bank economist.

For such countries, external shocks—such as those linked to foreign aid, trade, or even climatic conditions—contribute only a small, though still significant share of macroeconomic volatility.

Policies must be designed to control the level and variability of fiscal spending, to keep monetary and financial policy stable, and to avoid price rigidity, as in the case of pegged exchange rates (which often need to be drastically adjusted).

Build resilience through flexibility

Weaker “shock absorbers” in developing countries allow external fluctuations to produce larger macroeconomic volatility. Traditional shock absorbers like stabilization policies and diversified financial markets are frequently lacking in developing countries.

Fiscal policy is usually “procyclical” in poor countries, expanding in booms and contracting in recessions. But to absorb external shocks, fiscal policy should be more countercyclical. This depends on how far governments can reduce public debt to acceptable levels, increase saving in good times, and be seen as responsible spenders.

Financial markets in developing countries can potentially diversify away the risk posed by external shocks. But they are usually shallow, drying up in times of crisis when they are most needed. Governments can help deepen these markets by protecting creditor and shareholder rights.

“More recently, we have noted that microeconomic policies also play a role,” said Loayza, “When it is difficult for firms to reallocate resources, especially due to labor and financial market restrictions, countries become more vulnerable to economic shocks.”

Firms should be able to adjust to shocks by reallocating their resources across facilities, areas, and sectors. While competition and trade provide the basic mechanisms for this to happen, governments can help by reducing the burden of regulations.

Gear up for stormy weather

The bigger external shocks experienced by developing countries could come from financial markets (for instance, a sudden cessation of capital inflows) or from goods markets. Traditionally, governments have had three options—self-protection, self-insurance, and full hedging and insurance.

• Self-protection (i.e., low trade openness and tightly controlled financial markets) may reduce the vulnerability to external risk. But it blocks the benefits of global integration and increases the likelihood of distortions that will eventually result in large domestic shocks. Other domestic policies may be more appropriate to reduce vulnerability to foreign shocks. In 2007, Loayza and Raddatz found that labor market flexibility can reduce the output losses of terms-of-trade shocks.

• Self-insurance involves carrying resources over time, such as by accumulating foreign reserves in times of prosperity or robust growth. This is a popular option—the ratio of foreign reserves to imports has more than doubled in emerging economies over the past 15 years. But hoarding liquidity, which also implies sacrificing opportunities to invest, is less efficient than hedging through contingent financial instruments.

• Full hedging and insurance refers to transferring resources by securing contingent credit lines or trading commodity-linked options. Sophisticated hedging options are not yet available to developing countries, but financial markets do provide some hedging opportunities that are preferable to self-insurance.

“An optimal strategy to prepare for stormy weather would favor the insurance options,” said Servén, “What is most encouraging is that hedging and insurance instruments, once unfeasible for developing countries, are now becoming available to them. This is a very hopeful sign.”

More World Bank research on macroeconomics and growth

Related Reading

Norman Loayza and Claudio E. Raddatz, 2007. “The Structural Determinants of External Vulnerability.” World Bank Economic Review, Vol. 21, No. 3.

Norman Loayza, Romain Rancière, Luis Servén, and Jaume Ventura, 2007. “Macroeconomic Volatility and Welfare in Developing Countries.” World Bank Economic Review, Vol. 21, No. 3.

Claudio E. Raddatz. Forthcoming. “Are External Shocks Responsible for the Instability of Output in Low-Income Countries?” Journal of Development Economics.