34
The Great Recession and Developing Countries
capital adequacy ratio of about 11 percent (much higher than Basel II’s 8 percent) while banks were holding 17 percent. Improved regulation resulted in little toxic asset exposure on the part of the banks in most of the countries in our study. In Turkey, the banking sector’s improved performance and stability was due to the restructuring following the crisis of 2001, effective supervision, and a better regulatory framework. In both reasonably well-regulated banking systems helped mitigate the negative impact of the crisis. Until September 2008, emerging-market financial systems were relatively sheltered from the global contagion, and economic growth in these countries also remained strong. But the seizure of financial markets in advanced countries following the Lehman Brothers collapse finally triggered liquidity and credit difficulties in developing countries, the stoppage of capital inflows, the soaring of bond spreads, sharp falls in equity prices, and pressures on exchange rates. The large capital inflows that had stimulated countries in the boom period had already begun to level off when the subprime crisis erupted in 2007. But it was in September 2008 that the real decline in capital flows hit the emerging economies. The initial impact was mainly on portfolio flows. In India, inflows fell from an average of US$45 billion per year during 2003–08 to US$16 billion in 2009. Malaysia lost US$118 billion in the last quarter of 2008. Debt flows, which were much smaller than equity inflows, also slowed, not just because of supply considerations but also because of demand considerations as firms retrenched. FDI flows, however, were more stable as fresh flows slowed but existing commitments were maintained. The slowdown in (and reversal of) inflows did not last long. Equity markets rebounded quickly as capital flows resumed by the second quarter of 2009. By the end of the third quarter of 2009, the emerging-market index had risen by 52 percent. At the same time, by the second quarter of 2009, creditor banks in advanced economies stopped reducing their exposure to emerging countries. In tandem, most currencies strengthened although they remained below precrisis levels. During the boom, commodity and fuel producers had experienced terms-of-trade gains, which the crisis eroded fairly quickly; prices of commodities and fuel were corrected sharply in the last quarter of 2008 and the first half of 2009. Despite the steep fall in commodity prices, the