The global financial crisis. Which developing countries are most at risk?

14 October 2008
This blog is based on my new ODI Background Note: The global financial crisis and developing countries (PDF, 97kb).

The global financial crisis has caused a considerable economic slowdown in developed countries such as the UK, Germany, France and the USA. The USA and UK face the greatest financial crisis since the 1930s. By contrast, the Malawian finance minister told me last week that he projects growth in Malawi of more than 8% this year. Nigeria is also projected to see economic growth of 8%, and China 9%. Will all developing countries be isolated from the downturn in the west? If not, which countries are at risk and how might the global financial crisis affect them?

While there are reasons for optimism, many developing countries are likely to face challenges in the near future. African growth has been exceeding OECD growth by margins not seen for 25 years, and grew at more than 6% in 2007 thanks to structural change. East Asia’s growth was 9% in 2007 and is diverging as much as when the world was last in a significant downturn in the early 1990s. However, a recent IMF publication has revised growth forecasts significantly downwards over the past three months, not only for the UK, but also for China, Africa and India.

The magnitude of the crisis will depend on the response of the USA and EU. Trillion dollar rescue packages are launched around the world, but while the markets may eventually respond, the UK is already in a recession. Its magnitude will depend, in part, on how accommodating monetary policy can be, with the recent interest rate cut a sure sign that the authorities are concerned more about the financial crisis than recent inflationary pressures. There is less scope for expansionary fiscal policy – in fact these rescue measures have increased public debt.

This global crisis affects developing countries in two possible ways. It can affect stock markets in emerging markets.  We have seen share prices tumble between 12 and 19% in the USA, UK and Japan, while the MSCI emerging market index fell 23%. This includes stock markets in Brazil, South Africa, India and China. The Russian stock market ceased trading twice.

The second channel is through changes in the real economy, either directly or indirectly. A leading indicator of world trade and economic activity, the Baltic Dry index, has fallen by four fifths over the past five months. Exports, investment and growth are expected to fall, resulting in fewer jobs, lower incomes and more poverty.

Some developing countries are more at risk than others. Countries most at risk include those exporting directly to crisis affected countries. Four fifths of Mexican exports go a shrinking US economy that will have immediate and negative consequences. Countries that have diversified their exports to other countries may be affected indirectly, e.g. through eventual slowdowns in Mexico, China etc.

Exporting countries experiencing declining world prices are also at risk. Zambia will receive fewer copper export revenues (responsible for three quarters of its exports) as the price and demand for copper decreases. Also at risk are countries that export goods and services with high income elasticities, e.g. luxury goods including tourism. Caribbean and African countries already heavily dependent on tourism (sometimes accounting for up to 10-15% of GDP and employment) face declining tourism revenues and this will affect the poor.

Countries dependent on foreign direct investment, remittances, and development funds to finance the current account deficit will also be at risk. Investment deals are put on hold because it is impossible or too expensive to raise the financing.

Remittances from the USA to Mexico dropped by 4% in eight months. And countries dependent on capital flows, such as South Africa, cannot easily reduce interest rates to soften the blow. Oil importers are already suffering from a period of high oil prices and have seen their current account deteriorate from a balance to a 4% of GDP deficit over the past four years. Lack of trade finance is an obstacle to trade taking place and developing country governments (e.g. in Brazil) and development finance institutions (e.g. IFC) are considering their response.

Countries like India, with high government deficits, are also in a difficult position. Finally, countries dependent on aid face uncertain times and can only hope that developed countries continue to see the case for aid. The impact on developing countries will vary. It will depend on the response in developed countries to the financial crisis and the slowdown, and the economic characteristics and policy responses in developing countries.