Invited disaster

The financial liberalisation policies of developing countries have made them more vulnerable to global crises than ever before

THE past two weeks have made it clear that the developing world is far from immune to the storms raging in the financial markets in industrial countries. Stock prices in emerging markets have gone on roller-coaster rides similar to those in New York and Europe. Indeed, they have shown such very high volatility, going sharply up and down on a daily basis around an overall declining trend, that the pattern is reminiscent of the behaviour of stock indices in the last major international financial upheaval in 1929/30 – the Great Depression. And the credit crunch and freezing of inter-bank lending have been only too evident even in developing countries whose economic “fundamentals” are apparently strong and whose policymakers believe that they can decouple their economies from the global trends.
This almost immediate diffusion of bad news is the result of financial liberalisation policies across the developing world that have made capital markets much more integrated directly through mobile capital flows and created newer and similar forms of financial fragility almost everywhere. But the international transmission of turbulence is only one of the ways in which the global financial crisis can and will affect developing countries.
A medium-term implication for developing countries is the impact on private capital flows, which are likely to come down with the credit crunch and with reduced appetite for risk among investors. The past five years witnessed an unprecedented increase in gross private capital flows to developing countries. Remarkably, however, this was not accompanied by a net transfer of financial resources, because all developing regions chose to accumulate foreign exchange reserves rather than actually use the money. Thus, there was an even more unprecedented counter-flow from South to North in the form of central bank investments in safe assets and sovereign wealth funds of developing countries, a process that completely shattered the notion that free capital markets generate net financial flows from rich to poor countries.
The likely reduction of capital flows into developing countries is generally perceived as bad news. But that is not necessarily true, since the earlier capital inflows were mostly not used for productive investment by the countries that received them. Instead, the external reserve build-up (which reflected attempts by developing countries to prevent their exchange rates from appreciating and to build a cushion against potential crises) proved quite costly for the developing world, in terms of interest rate differentials and unused resources. While some developing countries may indeed be adversely affected by the reduction in net capital inflows, for many other emerging markets this may be a blessing in disguise as it reduces upward pressure on exchange rates and creates more emphasis on domestic resource mobilisation.
Similarly, it is also likely that the crisis will reduce Official Development Assistance (ODA) to poor countries. It is well known that foreign aid is strongly pro-cyclical, in that the developed countries’ “generosity” to poor countries is adversely affected by any reversal in their own economic fortunes. But in any case, development aid has also been experiencing an overall declining trend over the past two decades, even during the recent boom.
In fact, the developed countries were extremely miserly even in providing debt relief to countries whose development prospects have been crippled by the need to repay large quantities of external debt that rarely contributed to actual growth. Notwithstanding the enormous international pressure for debt write-off, the G-8 countries have provided hardly any real debt relief. When they have done so, they have provided small amounts of relief along with very heavy and damaging policy conditionalities and in a blaze of self-serving publicity. So the speed and extent of the debt relief provided to their own large banks by the governments of the U.S. and other developed countries, even when these banks have behaved far more irresponsibly, has not gone unnoticed in the developing world.
The recent crisis has also signalled the end of the commodity boom, which is bad news for developing countries that predominantly rely on commodity exports, and good news for commodity-importing developing countries. This follows a period of unprecedented increase in oil and other commodity prices, led largely by speculative investor behaviour. On October 14, oil prices (Brent Crude futures) fell to less than $75 a barrel from nearly $150 in early July. One important index of commodity prices, the Reuters-Jefferies CRB index, on October 14 was 40 per cent below its all-time high in July. While speculative behaviour was clearly behind the volatility in commodity prices over the past year, it is likely that such prices will continue to decline now because of the broader economic slowdown.
This may provide some breathing space in terms of inflation control for importing developing countries, especially oil importers. But remember that even at $75 a barrel, oil prices are still 300 per cent of their nominal level of only five years ago. And while world prices of important food items have also declined in the recent past, they are still too high for many developing countries with low per capita incomes and a large proportion of already hungry people. Indeed, the financial crisis may actually make it more difficult for many governments of poor developing countries to secure adequate commodity supplies to meet their people’s needs. The food crisis seems to have gone off the international media map, but it still rages for possibly a majority of the population of the developing world. The current global economic crisis will certainly not make it better.