The global financial crisis: financial flows to developing countries expected to fall by one quarter

13 November 2008
Comment
The global financial crisis is bound to have a major impact on  developing countries, with the International Monetary Fund (IMF) having downgraded its  growth forecasts for 2009 by nearly two percentage points over the last two months for both developed and developing countries. World growth is expected to be only 2.7% in 2009 (compared to 5% in 2007) and world trade is likely to stagnate. There will be significant effects on international financial flows, with private financial flows to developing countries expected to fall rapidly from record highs in 2007. With two key global events coming up (the G20 crisis summit on 15 November and the  Doha Finance for Development meeting from 29 November to 2 December), this blog asks how deep a fall developing countries can expect, and what should be done about it. 

Our latest research (Cali, Massa and te Velde, 2008), based on current updates and forecasts as well as on evidence on what happened in previous slowdowns and in the absence of policy responses, suggests that net financial flows to developing countries may fall by as much as $300 billion over 2007-2009, equivalent to a 25% drop.  Some countries are more vulnerable than others and while the drop is serious, it should be seen in the light of record increases in financial flows in the five years leading up to 2007.

The impact of the crisis on developing countries will affect four different types of international resource flows: private capital flows such as Foreign Direct Investment (FDI), portfolio flows and international lending; official flows such as development finance institutions; and capital and current transfers such as official development assistance and remittances.

FDI is normally one of the most stable external resources for developing countries, reaching a record $500 billion in 2007. However, there are signs of significant decreases. FDI to Turkey has fallen  40%  over the last year and  FDI to  India dropped by 40% in the first six months of 2008. FDI to China was $6.6 billion in September 2008, 20% down from the monthly average in year 2008 so far, and mining investments in South Africa have been put on hold. Previous downturns in world growth in the range of 2% have  led to falls in FDI to developing countries of around 25%. A similar drop in activity would imply a fall in FDI of $150 billion by 2009.

The crisis has led to a drop in bond and equity issuances and the sell-off of risky assets in developing countries. The average volume of bond issuances by developing countries was only $6 billion between July 2007 and March 2008, down from $ 15 billion over the same period in 2006. Between January and March 2008, equity issuance by developing countries stood at  $5 billion, its lowest level in five years. As a result, World Bank research suggests some 91 International Public Offerings have been withdrawn or postponed in 2008.

There is already financial contagion and stock markets have fallen around the world, with the largest losses since the 1930s. This has triggered retrenchment by investors, with reports that they  have  withdrawn $45 billion from Korea, $6.1 billion from South Africa, and $16 billion from India this year.

Remittances from developed to developing countries reached a record $251 billion in 2007 and are more broadly distributed over developing countries than private financial flows. Remittances from  Argentina, Finland, Japan, Norway, South Korea and Sweden with systemic financial crises in the last 20 years led to a 20%  drop in the value of remittances in the aftermath of the crisis. With around 80% of remittances from high income countries, remittances to developing countries may well drop by around $40 billion. Even so, remittances will still be one of the few stable international resource flows.

In the first eight months of 2008, remittances to Mexico (which depend almost exclusively on migrants to the USA) have decreased by 4.2%, with the strongest declines in August. Remittances to Kenya (which also depend on the US economy) have been hit even harder, with the Central Bank estimating a 38%  year-to-year drop in August.

Despite pressures on all government budgets during crises, the relationship between aid and GDP is not simple. Aid spending fell by 40%  in Finland and Japan during a period of crisis, but global aid did not fall during the downturn shortly after 2000.  Aid (worth $103.7 billion in 2007) may not increase as much as had been planned at the Gleneagles 2005 summit. On the other hand, development finance institutions (DFIs) such as the International Finance Corporation (IFC), European Bank for Reconstruction and Development (EBRD) and the Commonwealth Development Corporation (CDC), worth more than $50 billion in total each year, will have increased scope for higher exposure to developing countries. Other official institutions such as the IMF may also increase their lending.

The upcoming G20 crisis summit and Doha Conference need to consider ways to enhance international capital flows and promote ways to use a shrinking resource base more efficiently for development:

  • Developed countries must act to contain the global financial crisis by slashing interest rates further, coordinating their capital market responses and designing fiscal packages to stimulate the economy. Some fiscal stimulus may well come in form of aid to other countries.
  • Developed countries should  prevent emerging markets from sliding further into global turmoil through the use of loans and other support.
  • Suggestions that aid ‘will decline’ may  become a self-fulfilling prophecy. Now is the time for increased aid to poor countries. Economic growth in Africa will barely keep pace with population growth next year, for example. Smarter aid to manage economic shocks and provide safety nets will be vital, but maintaining aid budgets in the face of the impact of the crisis in donor countries will be a real challenge. Increased aid would lead to increased exports (a ratio of around  $7:$1) and hence home country economic growth while a fiscal stimulus in the UK or the developed world would involve leakages abroad  so it will be a trade-off where to stimulate the economy.
  • More emphasis on pro-cyclical development finance (e.g. by IFC and bilateral DFIs) should promote short-term trade finance as well as long-term capital for economically viable projects that now face credit constraints. A current review of the CDC at the UK Department for International Development (DFID)  suggests that the CDC could do more in crisis affected countries. The IFC, meanwhile, has already announced its plans to do more.
  • Encourage an enhanced, reformed and independent role for the IMF to monitor and prevent financial crises and intervene in credit constrained countries.
  • Broaden G8 discussions to promote good governance of public goods and foster coordination among developed and key emerging countries (e.g. cross-border monitoring, rules and incentives, establish and independent regulator of rating agencies).
  • Reinforce the need for quantity and quality resources. Business needs to continue to improve its development impact; remittances and diaspora investment must be facilitated; the domestic tax and resource base need to be enhanced; aid quality needs to be improved; and domestic institutions need to ensure maximum benefits from decreasing financial resources.