Introduction
Justin Yifu Lin has been the World Bank’s chief economist since June 2008. He is the first person from an emerging market to hold this role since the World Bank was founded over 60 years ago.
He was previously professor and founding director of the China Centre for Economic Research at Peking University. Lin, who received his PhD in economics from the University of Chicago in 1986, has written 16 books including The China Miracle: Development Strategy and Economic Reform, published in seven languages, and State-Owned Enterprise Reform in China, which is available in Chinese, Japanese, and English. Among his public roles in China, Lin has served as a deputy of China’s People’s Congress and Vice Chairman of the All-China Federation of Industry and Commerce. He has also served on international task forces and groups including the United Nations Millennium Task Force on Hunger, the National Committee on United States–China Relations; the Working Group on the future of the OECD (Organization for Economic Co-operation and Development) and the Reinventing Bretton Woods Committee. He gave the 2007–2008 Marshall Lectures at Cambridge University.
Slowdown in Emerging Markets
As the world economy is buffeted by the worst financial crisis for many decades—a crisis that entails grave implications for developing countries and threatens to undo the hard-won gains in growth and development of the past years—the world needs international economic cooperation more than ever.
Until the summer of 2008, there was a view that the “decoupling” theory of global economics would prevail, ensuring that developing economies would remain mainly immune to the financial crisis and economic downturn that was sweeping through the developed world. Now, that looks like wishful thinking.
Developing countries, which like the developed nations had thrived on the back of the 2002–2007 global economic boom, have faced the triple jeopardy of food, fuel and financial crises. Many are entering a danger zone. The international community is going to have work together to overcome this crisis and prevent it from triggering a development and humanitarian crisis.
Developing economies are feeling the fall-out in a number of ways, with countries with high balance of payments and fiscal deficits being the most vulnerable. Many nations are facing a rapid decline in exports, as the runaway trade expansion of 2002–2007 has sharply slowed. Commodity exporters were among those hit hard, since the reversal in GDP growth was accompanied by a drop in prices for food, fuel, and metals.
The crisis also dealt a major blow to investment in emerging markets. Portfolio investment fell, as investors removed their capital or chose to keep it closer to home. Foreign direct investment, though historically more resilient to economic and financial shocks, will also decline.
In addition, developing countries which still had access to capital started having to pay higher interest rates for the privilege, owing to the flight to safety and greater risk-aversion among lenders. Also, as labor markets slacken, foreign workers have suffered a disproportionate impact on their earnings, with remittances falling as a share of GDP.
Second-round effects of the crisis are likely to deepen the slowdown. Because of the investment surge of the past five years, many investment projects are underway in emerging economies. As investment financing dries up, two outcomes are possible. In some cases projects may be mothballed, making them unproductive and saddling banks’ balance sheets with nonperforming loans. In other cases, once the projects are completed, they will add to excess production capacity, increasing the risk of deflation.
As a result of all these factors, developing countries’ collective GDP growth is expected to slow to 2.1% in 2009, compared with an average of more than 7% in 2004–2007. Meanwhile, high income countries are in deep recession this year, with OECD economies likely to contract 3% and other high income countries 2%.
This highly synchronous growth collapse cannot be solely explained by trade linkages, but illustrates also that developing countries have been directly hit in their domestic economies by the financial crisis. The reversal of capital flows, collapse in stock markets, and in general the deterioration in financing conditions have brought investment growth in the developing countries to a halt, and in many developing countries investment is sharply declining.
Developing Countries Have Greater Resilience Now
Nevertheless, developing countries entered this crisis with advantages that they lacked during the shocks of the 1980s or 1990s. These included stronger macroeconomic policies and better-managed sovereign debt. Also, the move to flexible exchange rate arrangements has enhanced their ability to absorb shocks through exchange-rate adjustments.
The number of people worldwide living in extreme poverty has fallen by more than 300 million since the 1998 Asian crisis. The onset of the current crisis has also diminished inflationary pressures and reduced commodity prices, which has been a benefit for some developing countries.
Policymakers in the developing world will need to tap into all these advantages if they are to limit the fall-out from this crisis. Their first priority has been to prevent financial contagion from crippling their domestic banking sectors. Stock markets have declined sharply, some currencies have depreciated, and sovereign interest-rate spreads have risen with the “flight to safety” in world markets.
In the case of countries that entered the crisis with large balance of payments and fiscal deficits, many vulnerabilities are looming. Their larger financing and adjustment needs have strained the balance sheets of domestic firms and banks, raising the risks of a cascade of bankruptcies and bank failures. If fiscal resources are strained, they may find it difficult to mount domestically financed rescues of their financial sectors.
In the case of a prolonged credit crisis, the global economy could enter a period of deflation, similar to that experienced by Japan in the 1990s. In this scenario, the emerging economies would have greater scope for credit-financed industrial upgrading than their more developed counterparts.
The chances that monetary easing would ease the effects of the crisis are of course greater in countries that can afford such measures. However this tool is not available to all emerging economies. Some will, in fact, be forced to tighten their monetary policy and raise interest rates in a bid to avoid currency depreciations or capital outflows.
On the fiscal side, developing country governments have a number of tools at their disposal. Governments that still have the fiscal headroom can inject some fiscal stimulus into their economies, for example by boosting much-needed infrastructure investment, in order to stimulate domestic demand and offset the fall in foreign demand.
A second area of fiscal stimulus entails investing in social protection and human development to ensure that a temporary shock does not prompt permanent declines in the welfare of poorer households. There are many programs that have proved effective in this regard; governments should prioritize those that most effectively buffer the impact of crises on the poorest households.
In sum, policymakers in the developing countries face some difficult dilemmas. Solving them successfully will depend on how they behaved during the boom. Their ability to respond depends on whether they have freedom of maneuver to act in a prudent counter-cyclical way by boosting domestic demand without sacrificing the fundamentals. Some developing countries are going to find this much easier than others.
IFIs to the Rescue?
Armed with the lessons of past crises, the International Monetary Fund (IMF) is well-placed to help emerging markets make balance of payments adjustments to what should be temporary reversals in capital flows.
The World Bank Group is in a position to substantially boost its financial support to developing countries, focusing on the structural and social areas that are its mandate. The US$41.6 billion replenishment of its low-income-country window gives the Bank sufficient resources to help many countries invest in the infrastructure and social sectors.
In the case of middle-income countries, the International Bank for Reconstruction and Development (IBRD), the arm of the Bank that lends to emerging market countries, is in a position to make new commitments of up to US$100 billion over the next three years.
The International Finance Corporation (IFC), the Bank’s private sector arm, is launching four new facilities for bank recapitalization, infrastructure financing, trade facilitation, and refocused advisery services. Combined with financing mobilized from others, these new facilities could provide more than US$30 billion over the next three years.
In summary, the World Bank Group can help countries mitigate the risk of the financial crisis turning into a humanitarian crisis. It can also shore up banking systems and support the adoption of other financial reforms.
The Road to Recovery
In an increasingly integrated world, where crises are able to spread rapidly across the globe, the response needs to be global, coordinated, and fast. Policy challenges need to be addressed at the country level, but it is critical that the international community acts in a coordinated and supportive way to make each country’s task easier.
It is also critical that aid flows to developing countries be maintained, and that past commitments are honored and indeed supplemented. At some US$100 billion per annum, official development assistance volumes are modest in comparison to the trillions of dollars being spent on addressing the financial crisis in developed countries.
In the face of a prospective decline in private capital flows to developing countries, we must also intensify our efforts to catalyze and leverage private capital in support of development, including through innovative public–private partnerships. On current projections, net private capital flows to developing countries could drop from about US$1 trillion in 2007 to roughly half that level in 2009.
Governments need to coordinate approaches to avoid a return to “beggar-thy-neighbor” policies. I welcome the G20’s reaffirmation at the April 2009 summit of its commitment not to raise new barriers to investment or to trade in goods and services and commend leaders’ willingness to stick to the goal of concluding the Doha Development Round. With world trade volume in goods and services set to decline by 6.1% in 2009, pressing ahead with trade openness is crucial to global recovery.
The current global financial crisis poses significant challenges, but it also creates opportunities. A vigorous response to the crisis could set the stage for a new multilateralism that supports sustainable and inclusive globalization.
Specific Recommendations
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We need to lay the foundation for a new economic multilateralism that is more responsive to today’s realities and challenges.
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The IFIs must become more flexible and inclusive to accommodate rising economic powers such as the BRIC countries (Brazil, Russia, India, and China) and representatives of poorer countries. They must also embrace issues beyond trade and finance to include development, climate change and fragile states.
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We need concerted responses to reignite demand globally.
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Financial supervision needs to become more global.
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Financial supervision needs to keep pace with financial innovation.
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National governments must consider whether to add the control of asset price bubbles to the mandate of their monetary policy authorities.
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