The end of innocence: The fragile economics of development

23 September 2008
The end of the 1990s witnessed the rise and fall of the financial systems of many emerging markets (Mexico in 1994, South Asia in 1997/1998, Russia in 1998, Brazil in 1999, and Argentina in 2001). Most of them were due to macroeconomic instability and unsustainable exchange rate regimes; many collapsed due to bad corporate governance and loose regulation. Since then, developing world economies have embarked on a series of reforms and corrective measures, enabling them to grow fast and, so far, weather the storm of global financial turmoil. But for how long? Can developing countries isolate themselves from the financial turbulence in the developed world? Will the crunch negate any achievements made on the Millennium Development Goals (MDGs) in New York this week?

Ironically, the current financial crisis has been triggered by the champions of capitalism, the United States and the United Kingdom. Confidence due to long periods of economic growth tied to low inflation and low interest rates teased US and UK firms and households into taking risks beyond rationally advisable levels. This was due to financial innovations (securitisation and off-balance-sheet financing) but also to loose regulation, the same argument used against the developing world in the previous financial crises! Some argue that bonus-based compensation structures might also have led managers to take excessive risks thus becoming a key factor in the current financial crisis. But is the problem regulating compensation for risk-taking or regulating risk-taking itself? Is the current capitalist system at stake and will we see a rapid reaction into the direction of much more regulation?

The beginning of the end?

In the developed world, the weakest link in the chain were the subprime mortgages. Lending to borrowers with low credit scores, no income or no assets proved to be suicidal. The housing bubble burst, and this caused a systemic banking, corporate and household debt crisis that quickly spread through the globe and made stock markets crash repeatedly.

The list of casualties in the US and UK is long and is increasing faster than expected. Northern Rock, Fannie Mae, Freddie Mac, Lehman Brothers, Bear Sterns, HBOS, Morgan Stanley, Washington Mutual, and AIG are just a number of remarkable examples that together with the recent “Black Monday” on Wall Street on 15 September give an idea of the magnitude of the current problem. Central banks have been forced to intervene several times, but any resolution to the financial crisis is complex in a world dominated by deregulation, an economic turndown in the US and Western Europe and by the spread of financial derivatives that have shifted risks from one country to another thus making it very difficult to discover where the losses have accumulated.

You can run, but you can’t hide!

Emerging markets have learned their lessons and are experiencing stability and sustained economic growth. Moreover, over the past six years, emerging markets like China, Brazil and others have experienced an impressive upward trend in their stock markets that has been weakened but not broken by the current economic slowdown. Emerging market economies are the new drivers of global growth and in the current downturn they seem to be playing so far an important stabilising role.

The April 2008 World Economic Outlook suggested that developing and emerging economies accounted for about two-thirds of global growth over the past five years. Furthermore, they also accounted for one third of global trade and for more than one-half of the total increase in import volumes since 2000. Improved policy frameworks and enhanced trade among themselves also helped developing and emerging economies become less dependent on cyclical performance in the developed world, thus making them more resilient to overseas shocks and enabling them to offset the recent repeated waves of economic and financial shocks in developed economies.

A recent IMF Working Paper found evidence for convergence of business cycles within developed countries and developing countries, but that there has also been divergence between these groups. Many argue that, thanks to this decoupling, emerging markets are serving as cushions for poorer countries (such as in Africa) against an otherwise new global recession and they would point to evidence regarding the apparent immunity of their financial sectors and economies to the severe western infection. For example, they would highlight that in 2007, when the United States was hit by the subprime mortgages crisis, the MSCI emerging markets index rose by 36.5 per cent and the JPMorgan emerging markets bond yielded 6.4 per cent, while the Standard & Poor’s 500 index rose only 3.5 per cent over the same period.

But this might not last forever, and a number of recent events might be the first warning signals. Last week, for example, Russia was forced to close its main stock exchanges for three consecutive days. The JPMorgan emerging markets bond index has fallen by more than five per cent and the MSCI emerging markets index by 14 per cent since the beginning of the month. China and India have also been hit by the financial crisis. According to the IMF, China 's growth rate is expected to fall from 12 per cent in 2007 to around 10 per cent in 2008-09. Moreover, seven listed banks in China are reported to have had bond holdings of $721 million in the US investment bank Lehman Brothers, and the Bombay Stock Exchange Sensitive index (Sensex) has fallen by about 31 per cent over the last year.

The globalisation process has increased and intensified the transmission mechanisms among countries all over the world and so the shock waves generated by the western financial turmoil will also hit the developing world sooner or later. Indeed, emerging markets will start feeling the effects of the global repricing of credit risks: an increase in the cost of external financing on one hand, and a reduction in funding availability on the other (e.g. project or corporate finance for investment projects in developing countries). Moreover, the emergence of what seems to be a new era of political volatility is making investors less confident and more risk averse even towards the developing world. Russia seems determined to reassert its military and political power in the world. This certainly adds to the nervousness of investors within and outside emerging markets, and the risk of financial flows jumping from one emerging market to another searching for safety will sooner or later bring one of their financial systems to the brink of collapse. Once this happens a domino effect seems unavoidable. There may also be further effects of the current economic and financial downturn on developing countries such as pressure on aid budgets, project finance under pressure and weaker demand in developed countries eventually leading to a slowdown in China and India. All of these issues need to be monitored more closely in the future in order to understand how linkages between the developed and developing world might work.

What should we expect?

While it is impossible to predict the future, it may be useful, given the sequence of events that have characterised the current crisis, to identify two plausible scenarios, one catastrophic and one moderately good. Nouriel Roubini, professor of economics at New York University, suggests we are already at the edge of a disastrous financial meltdown, and probably nothing can be done to prevent it. Prof. Roubini describes a 12 step list towards financial disaster, and guess what? We maybe have already reached step 12, that is ‘a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices’. If this is true, then not much else can be done to prevent a financial crisis.

According to the moderately good scenario, it is not yet too late to learn lessons and prevent a crisis, and developed countries might still be in time to fix current troubles and avoid their recurrence in the future with little effect for developing countries. However, in order to do this, it is necessary to develop and adopt the right policy measures. More transparency, adequate capital requirements, enhanced competition among rating agencies, international coordination and improved risk accounting are some of the measures that need to be promoted. But more thinking needs to be done by governments in developing and developed countries to ensure that developing countries are well equipped to weather the effects of the current financial crisis which is becoming ever more likely that they will experience.

Whatever the scenario, many developed countries are facing a period of economic hardship and recession is under way in a number of them. In this context, we cannot forget the importance of doing development in a downturn as highlighted by Simon Maxwell in one of his most recent ODI Opinions. While the poorest countries might be saved by resilient growth in emerging markets ( China, India, etc.), it is also possible that emerging markets have not decoupled from the developed countries. It could be just a matter of time before the crisis will also hit them with repercussions for the poorest countries as well. However, thanks to the stability and continuous economic expansion of the emerging markets, the overall effect of the crisis on the global economy has been reduced. Donors should be grateful that development in developing countries is currently helping the global economy; promoting growth and stability in developing countries supports poverty reduction as well as the provision of global public goods.

It is difficult to argue that the worst is now over or to predict precisely what will happen next. The crisis is, however, likely to reignite a number of debates on whether the current financial system is up to scratch and whether developing, emerging and developed countries are now decoupled, or still fully linked. Will developing countries see their economic prospects decline, and what would be appropriate policy responses? Moreover, there are a number of open questions to which we need to find an answer urgently: What should developing countries do while governments around the developed world are intervening in financial markets? Is there a role for development finance? What is the current and future role for Bretton Woods institutions in the current financial crisis? And how does all this relate to the Millennium Development Goals? These will be the subject of an ODI meeting series this autumn.