The global financial crisis has now stretched across the world, a crisis which emerged in developed countries has already spread to the developing world. Forecasts of growth in developing countries have been downgraded significantly in recent weeks even from those made two months ago. Questions linger as to how deep and for how long these difficulties will stretch, which countries will be most affected and what are the channels through which the contagion might work? What will this mean for long term efforts to promote growth and poverty reduction in developing countries? Must the credit crunch turn into a development crunch, or can this be avoided? And how should policy makers and development officials respond?
In the third meeting of an ODI series on the financial crisis Richard Laing, CEO of CDC Group, and Dirk Willem te Velde, Research Fellow at ODI discussed both the effects of the financial crisis on development finance and the role of development finance in responding to the financial crisis. Simon Maxwell, Director of ODI, chaired the meeting.
A. Simon Maxwell, Director of ODI, introduced the third in a series of meetings about the global financial crisis and developing countries: the first meeting made the point that the crisis has turned into a recession and identified what the main drivers of the impact of the crisis would be for developing countries; the second session covered issues related to financial regulation and their implications for the developing world; now need to figure out what to do.
B. Dirk Willem te Velde, ODI Programme Leader and Research Fellow, discussed the role of development finance and covered four issues:
1. Features of the global financial crisis;
2. Role of development finance;
3. Whether certain countries are at risk of relapse;
4. Possible policy responses to the crisis.
- The Global financial crisis in developed countries will affect developing countries through real effects and lower financial flows:
- Concern about a triple ‘F’ crisis: food crisis, fuel crisis, financial crisis. Required a triple ‘S’ response: thought about shocks, social protection, stability.
- Private capital flows: after record flows to developing countries until 2007 a decline of $300-400 billion is now expected over two years. Evidence of this includes decreasing international bank lending, declining portfolio investment, initial public offerings (IPOs) put on hold, falling stock exchanges and foreign direct investment.
- Public financial flows: in previous downturns some developed countries cut aid but no simple link exists between downturns and aid cuts.
- Real sector: in times of crisis remittances outflows will fall, evidence of this now in Mexico and Kenya.
- Country case studies: African countries experienced fast growth based on strong services sector. Now some successful countries may be at risk of downturn in terms of financial flows due to a reduction in remittances, international bank lending or commodity price falls.
- Three possible responses to question if developing countries are prepared:
- Consider if the shocks are understood and managed well, economic policies are in terms of accelerating normal structural reforms, or cyclical reforms, the role of international support and the effects on governance issues (as there are already protests in some developing countries).
- Consider adequacy of social protection and safety nets.
- Consider whether current global financial rules ensure financial stability. This includes rules on anti cyclical capital adequacy ratios and rules on funding of the assets and relates to the G-20 meeting in London in 2009 and the UN commission headed by Stiglitz. He read out Stiglitz’s findings on problems facing American institutions made in 1994. He also suggested that tax havens are out, but transparency is back in.
- Development Finance Institutions (DFI):
- Examples of DFIs include IFC (part of the World Bank group), Asian Development Bank, and UK’s CDC. These institutions have experience in lending and investing in equity using state-backed guarantees (and directed credit issues are back).
- Need to recognize the considerable contribution of DFIs, likely that international capital and access to this capital would be a constraint on growth.
- But we need to think more about:
- quality and quantity of DFIs’ flows: quality is important in period of abundance of capital; quantity is important when capital is scarce.
- alignment of incentives for investment officers with development impact.
- transparency in DFIs’ sector.
- CDC’s mission as determined by the UK government: to generate wealth in emerging markets in poorer countries by providing capital for investment in sustainable and responsibly managed private sector companies.
o CDC works differently from other DFIs because it has subcontracted investment decisions to fund managers and provided capital to funds managed by local teams with local experience and knowledge enabling private equity industry to flourish.
o CDC supports economic growth through the private sector. Main focus on Sub-Saharan Africa and South Asia. Recently, money put to work in China, South East Asia and Latin America. CDC only invests in equity while other European DFIs invest mainly in debt.
- Markets and drivers:
o In China and to a less extent in all the other emerging markets, the new middle class serve as a protective shield from the global recession.
o He reviewed the trend of the MSCI emerging markets index over the last 20 years characterized by the Asian crisis in the late 90s, dot com bubble, etc. The MSCI emerging markets index increased by 18% per annum from 1987 to 1997, declined by 11% per annum in the period 1997-2002, and then experienced a spectacular growth of 38% per annum in 2002-2007 thanks to low inflation and availability of debt. In 2008 the index fell by 61 per cent, consequently falling back to 1993 levels and driving a decline in commodity prices.
o Massive demand for equity investment in the private sector in poor countries with huge potential for investment in the private sector.
- Current concerns:
o Growth issues: economic growth will clearly be hit by the crisis but not all news are bad. Indeed, intra-continental trade and growth will offset lower exports; discretionary income continues to generate some growth that will broadly offset export issues; the effects of commodity prices will be mixed and create losers but also some winners.
o FDI and remittances declining.
o Aid flows at risk
o Capital markets issues: restrictions on bank debt, trade finance (letter of credit not provided), IPOs.
However, the situation is not as bad as in the Western economies, since (i) several emerging markets’ banks do not use international market wholesale financing but use local funding, (ii) liquidity is still there, but (iii) banks are more cautious. Now, there is a need to release caution by providing more support for businesses, especially SMEs.
- Fast moving crisis: up until June this year, there was mixed performance, with some countries even stock markets even up; but since June the MSCI emerging markets index fell in virtually every market in the world. This is a clear signal that the initial thought that some parts of the world would not have been affected by the crisis is incorrect. The evidence is not of decoupling but of convergence.
- Issues for DFI:
o Redirecting funds to the private sector to try to offset some of the effects of the crisis.
o IFC initiatives: plans to double its global trade finance program from $1.5 billion to $3 billion, and equity fund to refinance/recapitalization of distressed banks for funded infrastructure projects. Re-evaluating all projects and as a consequence there may be a reduction of investment in sectors other than banking.
o DFI balance sheets suffering: cash flows from equity portfolio will be slower and lower. As a consequence, DFIs may be doing less in a time when they should be doing more.
o Revised investment policy for CDC: Most focus of all DFIs on low income countries. CDC will now increase focus further with 75 per cent of new investments in low income countries (previously 50 per cent) and 50 per cent in Sub-Saharan Africa (previously 40 per cent).
D. Simon Maxwell introduced the discussion with three exam questions and requested comments on the presentations and what developing countries and donor countries should be doing to avoid the worst impacts of the recession.
- Richard Laing explained the logic of CDC investment in the private sector – although the state provides the proper environment for growth, only the private sector can generate wealth, employ people and support taxes. He continued to discuss the need for infrastructure to improve economic growth. DFIs must work with local markets on accessing local capital there for infrastructure. Models are currently in place, including the successful telecoms sector in Africa, but in some sectors, such as water, the private sector model is much harder.
- Richard Laing also responded to a question regarding the possibility of African small and medium enterprises (SMEs) working with foreign SMEs. He stated that there are real opportunities for medium and large enterprises with good examples of Chinese and Indian companies operating in Africa and joining forces with local businesses, but he has not seen this much in small and medium enterprises.
- Simon Maxwell prompted a question about reasons to give money to DFIs rather than IDA and grant making models. Regional development banks said to be overcapitilised and said to generate greater leverage and capital. Richard Laing responded by discussing the spectrum of development. In order to reduce poverty, growth must be generated by the private sector.
- Dirk Willem te Velde discussed mandates and DFIs: most bilateral DFIs are mandated to deal with the private sector. Cash flows and capital adequacy ratios were increasing over the past few years but then fell in the case of the IFC which is what is expected. But there is still a lot of cash. He emphasized thinking about incentives for investment which are mandated to invest in profitable projects. Question of possible leveraging of IFC funding and other types of development finance for less profitable projects. Aid could be used to leverage capital to those countries and sectors most affected by the crisis, such as trade finance. Mechanisms, such as Global Partnership for Output Based Aid should be strengthened to flexibly put money in affected sectors.
- Richard Laing emphasized that DFIs must be careful when putting money to work in less profitable businesses. Deliberately investing at sub-optimal rates leads to the risk that businesses will fail and the private sector will see inadequate returns and walk away.
- In response to a question concerning the international DFIs versus sovereign bonds, Richard stated that CDC’s mandate is ultimately not to exist; if private sector companies could raise appropriately priced capital on the local debt or equity markets then CDC would not be required.
- A member of the audience presented a sceptical point about the role of DFIs and the shock being larger than the investment and the fact that cash flows will be going down due to the fall in profitability of investments. He reiterated Dirk Willem te Velde’s earlier point that a link between a downturn and a downward adjustment in aid does not necessarily exist, and asked the panel to discuss whether policy should focus on aid or injecting more money into the private sector. Richard Laing emphasized that funding to the private sector will create the best long term effect. Dirk Willem te Velde stated that both aid and DFI should be used and combined in transparent ways and that aid funds be used to leverage in DFI finance.
- Richard Laing pointed out that discussion about sovereign wealth funds has declined but the World Bank continues to try to put them to work in foreign markets.