Development Outreach: December 2009 - Growing Out of Crisis by World Bank Group Publications

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Outreach P U T T I N G

K N O W L E D G E

WORLD BANK INSTITUTE L E A R N I N G

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D E V E L O P M E N T

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W O R K

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MARY MCNEIL

ABOUT THIS ISSUE

FOUNDING EDITOR

EDITORIAL BOARD very crisis has its lessons. A global financial and economic convulsion of the magnitude we have just experienced should offer more lessons than most. That is why we have selected “Growing Out of Crisis” as the theme for this issue of Development Outreach. As 2009 draws to a close, policymakers in all countries are assessing the fault lines in their economic management systems, and working together in international forums such as the G-20 and IMF/World Bank meetings, among others, to define an agenda for reform, and to improve international coordination systems. We asked some of the world’s leading economic thinkers, as well as regional experts and policymakers, to discuss the impact of the crisis from different perspectives and in different parts of the world, and to reflect on changes at national and international levels that would better protect us from the next crisis. World Bank President Robert Zoellick, in an address at Johns Hopkins University in September, pointed to the vital role of developing economies in leading the world out of this crisis. Indeed, this is perhaps the major watershed produced by the crisis. The emerging market countries have arrived, the G-20 has replaced the G-7, and more hands are on the levers of global economy. Not least, this has had implications for international financial institutions. The World Bank Group committed itself to lending $100 billion over three years to provide a counter-cyclical stimulus to the developing world. The IMF has also tripled its lending to $750 billion. Both institutions must seek additional support to cover these new demands, and both face pressure to reform their governance and representation to reflect shifting global economic influences. The World Bank Institute, whose mission includes capacity building for government officials and other stakeholders, responded to the economic and financial crisis by hosting videoconference discussions among policymakers in developing countries’ finance, planning and trade ministries, as well as central banks. A series of seminars, Pathways to Development, will follow, aimed at drawing further lessons to help countries grow out of crisis. For his guest editing of this issue of Development Outreach, I would like to thank Raj Nallari, Lead Economist with WBI’s Growth and Crisis Unit.

Christopher Neal EXECUTIVE EDITOR

SWAMINATHAN S. AIYAR ECONOMIC TIMES OF INDIA, NEW DELHI, INDIA

MICHAEL COHEN NEW SCHOOL UNIVERSITY, NEW YORK, USA

PAUL COLLIER OXFORD UNIVERSITY, OXFORD, UK

JOHN GAGE SUN MICROSYSTEMS, PALO ALTO, CALIFORNIA, USA

JOSEPH K. INGRAM PERUGIA, ITALY

KWAME KARIKARI SCHOOL OF JOURNALISM AND COMMUNICATIONS, THE UNIVERSITY OF GHANA, LEGON, GHANA

VIRA NANIVSKA NATIONAL ACADEMY OF PUBLIC ADMINISTRATION, KIEV, UKRAINE

PEPI PATRON CATHOLIC UNIVERSITY, LIMA, PERU

J. ROBERT S. PRICHARD TORSTAR, TORONTO, CANADA

RAFAEL RANGEL SOSTMANN MONTERREY TECH UNIVERSITY SYSTEM, MONTERREY, MEXICO

VIVIENNE WEE CENTRE FOR ENVIRONMENT, GENDER AND DEVELOPMENT, SINGAPORE

Development OUTREACH is published three times a year by the World Bank Institute and reflects issues arising from the World Bank’s many learning programs. Articles are solicited that offer a range of viewpoints from a variety of authors worldwide and do not represent official positions of the World Bank or the views of its management.

CHRISTOPHER NEAL EXECUTIVE EDITOR

ANNA LAWTON MANAGING EDITOR

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PHOTO CREDITS Unless otherwise noted, all images from Newscom. Cover: Naylor Design, Inc., Washington, DC; Page 4: Richard B. Levine/Newscom; Page 8: Newscom; Page 12: AFP Photo/Kirill Kudryavtsev; Page 13: John Dooley/Sipa Press; Page 16: AFP Photo/Romeo Gacad; Page 18: AFP Photo/Mauricio Lima; Page 19: AFP Photo/Andrei Smirnov; Page 20: AFP Photo/ Attila Kisbenedek; Page 22: AFP Photo/Rajesh Jantilal; Page 25: Benedicte Desrus / Sipa Press; Page 28: Benedicte Desrus / Sipa Press; Page 29: Newscom; Page 32: AFP Photo/Joseph Agcaoili; Page 34: John Dooley/Sipa Press; Page 37: Topshots AFP Photo/Liu Jin; Page 38: AFP Photo/Roslan Rahman; Page 39: AFP Photo/Mandel Ngan; Page 41: Newscom; Page 43: Sipa Press; Page 45: AFP Photo / Bob Low; Page 47: Newscom; Page 50: Rod Rolle/Sipa Press; Page 53: Richard B. Levine/Newscom.

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DEVELOPMENT

Outreach VOLUME ELEVEN, NUMBER THREE

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SPECIAL REPORT

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GROWING OUT OF CRISIS

DECEMBER 2009

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Coming Out of Recession: The role of business in alleviating poverty V. K A S T U R I R A N G A N A N D D J O R D J I J A P E T K O S K I

After the Crisis RETHINKING POLICIES

ROBERT B. ZOELLICK

Growing Out of Crisis Guest Editorial RAJ NALLARI

The Economic and Fiscal Consequences of Financial Crises: North and South CARMEN M. REINHART

CURRENT CRISIS: IMPACT AND POLICY RESPONSES 13

Shock Producers and Shock Absorbers in the Crisis HANS-WERNER SINN

Trade Openness Is Now More Important Than Ever ANNE O. KRUEGER

The Imperative for Improved Global Economic Coordination JOSEPH E. STIGLITZ

Lender of Last Resort and Global Liquidity: Rethinking the system MAURICE OBSTFELD

The Dollar Dilemma BARRY EICHENGREEN

The Crisis and the World’s Poorest

AU CONTRAIRE

M A R T I N R AVA L L I O N

Growth Is Disappearing and May Not Recover in the Medium Run VLADIMIR GLIGOROV

Government Actions and Interventions: More harm than good? J O H N B . TAY L O R

South Africa’s Policy May Offset the Financial Downturn BRIAN KAHN

Small States Face Big Challenges DWIGHT VENNER

Policy Responses to the Global Economic Crisis JUSTIN YIFU LIN

54 KNOWLEDGE RESOURCES 55 BOOKSHELF 56 CALENDAR OF EVENTS

AFTER THE CRISIS BY ROBERT B. ZOELLICK Excerpted from a speech delivered at the Paul H. Nitze School of Advanced International Studies of the Johns Hopkins University, September 28, 2009. G R E AT U P H E AVA L S produce shock waves that widen cracks in political, economic, and security orders. Sometimes the old orders break. Yet it can be in the power of leaders and peoples to shape the directions of change.

Outcomes are not predetermined I N 2009,

we are living through an upheaval that is changing our world. What will be its implications for the future? The last 20 years have witnessed a huge economic shift. The breakdown of the planned economies in the Soviet Union and Central and Eastern Europe, the economic reforms in China and India, and the export-driven growth strategies of East Asia all contributed to a world market economy that vaulted from about 1 billion to 4 or 5 billion people. This shift offers enormous opportunities. But it has also shaken an international economic system forged in the middle of the 20th century with patched-up changes in the decades since. Already, we can see potential shifts in power and institutions and international cooperation. In part, the shifts will depend upon how the parties adapt to new circumstances; in part, upon the rapidity of the recovery; in part, upon changes in who holds the world’s capital, technology, and human resources and what they do with them; in part, upon how countries cooperate—or do not.

What are the perceptions and realities of power after this crisis? is that the post-crisis political economy will reflect the rising influence of China and India, and of other large emerging economies. Supposedly, the United States, the epicenter of the financial crisis, will see its economic power and influence diminish.

THE CURRENT ASSUMPTION

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Indeed, today, China acts as a stabilizing force in the global economy. Together, China and India account for 8.5 percent of world output. They and other developing countries are growing substantially more rapidly than developed countries. And yet…China’s future is not yet determined. Its rapid recovery in 2009 was fueled by an expansion of credit of 26 percent of GDP in the first eight months of this year. This flood is now easing, and authorities are likely to limit it further for fear of effects on asset prices, asset quality, and eventually general inflation. China still faces big uncertainties in 2010. The United States, in turn, has been hit hard by the crisis. But America has a culture of resilience to set-backs, adapting to new circumstances and remaking itself. The future for the United States will depend on whether and how it will address large deficits, recover without inflation that could undermine its credit and currency, and overhaul its financial system to preserve innovation while adding to safety and soundness.Understanding shifting power relations is fundamental for shaping the future—as the Bretton Woods delegates appreciated. The political basis for that system was forged through a shared experience in failed responsibility after World War I and a clear assessment of power after World War II. Change those power relations—and the nature of the markets that connect them—and the system looks out of touch.

Will the U.S. dollar remain the predominant reserve currency? gave way in 1973 to floating rates, with the dollar as the world’s main reserve currency. For all the questions about the dollar’s reliability as a reserve currency, its value strengthened during the crisis as it offered investors a safe haven. But the United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar. T H E B R E T TO N WO O D S C U R R E N C Y SYS T E M

The Bretton Woods system was forged by 44 countries at a time when power was concentrated in a small number of states. The great waves of decolonization were just stirring; the few developing countries were seen as objects, not subjects, of history. That world is long passed. The new realities of political economy demand a different system.

What will be the role of developing countries after the crisis? the growing importance of the large emerging economies, especially China and India, but others as well. In effect, the world economy is being “rebalanced” toward the relative shares of some two hundred years ago, before the industrial revolution, plus a new North America. The rising developing economies should play a key role in the recovery. Most forecasters expect demand to be tepid, with a pullback by the U.S. consumer. Many developing countries could expand demand if they can get access to financing. They have fiscal space to borrow, but cannot get the volumes they need at reasonable prices without crowding out their private sectors. Moreover, the middle-income countries are home to 70 percent of the world’s extreme poor. The World Bank Group and the regional development banks can assist. The World Bank Group can offer a counterweight to financial and trade protectionism by supporting this development globally. We have launched a new Asset Management Corporation, through IFC, our private sector arm, to invest in banks, equity, infrastructure, and debt restructuring. We have a parallel effort to support and invest in the development of local currency bond markets. Longer-term investors—such as sovereign and pension funds—now recognize that developed markets pose risks, too, and developing markets can offer good growth prospects. Coming out of this crisis, we have an opportunity to reshape our policies, architecture, and institutions. We have an opportunity to craft a new global system for a 21st century of “Responsible Globalization”—one that would encourage balanced global growth and financial stability, embrace global efforts to counter climate change, and advance opportunity for the poorest. It means expanding the benefits of open markets and trade, investments, competition, innovation, entrepreneurialism, growth, information—and debates on ideas. It must be a globalization that is both inclusive and sustainable—expanding opportunity with care for the environment.

THE CRISIS HAS UNDERSCORED

Yet it won’t happen by itself AT T H E G-20 S U M M I T I N L O N D O N I N A P R I L , leaders stared into an economic abyss. The danger today is not freefall, but complacency. As the crisis wanes, it will be harder to press countries to cooperate in “building back better.” Peer review of a new Framework for Strong, Sustainable and Balanced Growth agreed at the April G-20 Summit is a good start, but it will require a new level of international cooperation and coordination, including a new willingness to take the findings of global monitoring seriously. Peer review will need to be peer pressure. Global finance and currencies. The trading system. Inclusive and sustainable development. Climate change. States struggling with fragility and conflicts. And a host of other security issues. Each topic is important on its own. But each interconnects with the others. The countries of the world will never deal effectively with this agenda unless they cooperate. The economic multilateralism of another age does not reflect today’s realities. We need to modernize multilateralism and markets. As agreed at the Pittsburgh Summit, the G-20 should become the premier forum for international economic cooperation among the advanced industrialized countries and rising powers. But it cannot be a stand-alone committee. Nor can it ignore the voices of the over 160 countries left outside. The G-20 should operate as a “Steering Group” across a network of countries and international institutions. It could recognize the interconnections among issues and foster points of mutual interest. The question is whether leaders can cooperate in steering the changes. They will be drawn to the interests of the national publics they represent, as they should. Yet they also will be challenged to recognize and build common interests, not only case-by-case, but through institutions reflecting a “Responsible Globalization.” Bretton Woods is being overhauled before our eyes. This time, it will take longer than three weeks in New Hampshire. It will have more participants. But it is just as necessary. The next upheaval, whatever it may be, is taking form now. Shape it or be shaped by it. Robert B. Zoellick is President of The World Bank Group.

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GROWING OUT OF CRISIS Guest Editorial BY RAJ NALLARI on subprime housing loans in the United States, estimated at about $100 million in early 2007, lead to a global financial and economic crisis? Worldwide stock markets plunged and housing values declined sharply during 2007-08; and the IMF has projected that output losses are likely to be about $4.7 trillion between 2008 and 2015. Most experts were blind-sided by the magnitude and speed with which this financial crisis, which originated in the U.S., spread to the rest of the world. Large investment banks, big corporations, millions of jobs, and about $1 trillion of private capital flows to developing countries evaporated within days of the collapse of Lehman Brothers on September 12, 2008. Some argue that if Lehman had been bailed out, the U.S. financial system would not have melted down and, consequently, a global recession could have been avoided. Others, such as Kenneth Rogoff (The Economist, 9/12/09), argue that even if Lehman had been saved it would still have had to be sacrificed later, along with other investment banks, because the system had exceeded sustainable levels: trillions of dollars had been borrowed against an asset bubble in stock and house prices. In this issue of Development Outreach, we asked experts with diverse perspectives to address the key questions that concern the developing countries. These questions include: what were the prevailing economic conditions when the crisis struck; what was the impact during the first year of the global crisis; what policies have the developing countries taken in response; and what effects will those policies have on output, employment, poverty, and public finances. In this overview article, we provide our own thoughts on these questions. H OW C O U L D S M A L L L O S S E S

What were the economic conditions before the crisis? A “ P E R F E C T S TO R M ” WA S B R E W I N G as U.S. and European housing defaults began piling up in late 2006, oil prices doubled during late 2007 and early 2008, and rice, wheat, and corn prices jumped by 40-50 percent during the same period. Sustained global growth between 2000 and 2007, especially in emerging and developing economies, had catalyzed demand for many commodities, including oil, metals, and food. At the same time, supply had been slow to catch up to this growing demand, causing prices to rise. Beginning in 2006, a number of other factors also contributed to the rapid jump in food prices. For example, unfavorable weather conditions

reduced harvest yields; rising biofuel production in advanced economies jacked up corn prices as well as feedstock costs; the rise in oil and energy prices boosted production costs for food commodities through higher prices for transportation fuels and fertilizer; and the growing use of export restrictions by food exporters as a way of raising domestic food supplies and lowering domestic prices has put pressure on world prices, contributing substantially to the run-up in rice prices in 2008. Finally, the bursting of the housing bubbles in the U. S. and Europe in 2007 led to a surge in defaults and foreclosures,1 which resulted in a plunge in the prices of mortgage-backed securities. These financial losses have left many financial institutions with too little capital relative to their debt. They have, therefore, been unable to provide the credit required for economic growth. Many other culprits have also been implicated and it is more than a government or regulatory failure. Markets also failed. A long period of abundant liquidity, low interest rates, and a global “search-for-yield” led to rising asset prices. In addition, there was a steady build-up of macroeconomic imbalances as Asian countries and oil-importers were pursuing policies of foreign exchange reserve accumulation. All this was taking place at a time when financial systems were going global and integrating through new technologies. Complex, nontransparent financial instruments were mispriced and levels of risk were misunderstood. Regulators in some cases failed to respond to, and in other cases facilitated the build-up of imbalances. Service providers, including credit rating agencies, loan originators and payment collectors were also involved. When Lehman Brothers went belly-up, the global financial system itself was on the verge of collapse. Globalization, defined as the increasingly free flow of ideas, people, goods, services, and capital that leads to the integration of economies and societies, has become a major force for global change. It has also added to the number of channels through which shocks can be transmitted across borders more quickly. As shocks have become larger and more frequent, economies from North and South have to move in lock-step. This co-dependence reduces the ability of individual economies to manage their way out of a crisis, especially when it is the largest economy that is transmitting the shock.

What has been the immediate impact of the crisis? WO R L D O U T P U T D E C L I N E D by an unprecedented 2.25 percent (annualized) in the last quarter of 2008; and global trade and industrial activity have fallen substantially since November 2008. All the major industrial economies entered a

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period of deep recession, and several emerging markets were sputtering in late 2008. Growth in emerging and developing economies has decelerated abruptly to 3.25 percent, mostly because of external pressures—lower foreign demand, reversal of capital inflows, and plunging commodity prices. Anemic global growth has reversed the commodity price boom and lowered inflation. These price declines (except for gold) have dampened growth prospects for a number of commodityexporting economies. In the first few months of the global crisis, there were massive lay-offs of workers in China’s garment, toy and electronics manufacturing sectors, in Bangladesh’s jute mills, in Cambodia’s garments industry, and in India’s diamond polishing, textile and garment firms. Martin Ravallion’s article in this issue describes how more than 50 million people may have been pushed below the poverty line during the first few months of the crisis. If the Asian crisis is any indication, poverty levels are likely to be much higher in several of the affected countries and to remain so, long after the global economy recovers. Professor Sinn’s essay makes an interesting point: that the U.S. was the main shock producer because it reduced its imports more than its exports during late 2008 and early 2009. To a lesser extent, China, Brazil, the United Kingdom, and South Korea followed a similar practice. In contrast, Germany, Japan and Russia were the main shock absorbers as their imports exceeded exports during the same period.

How did policy makers react to the global economic crisis? early on that the current global downturn was far from your normal garden-variety recession. The central banks were the first to react, while commercial banks were sharply curtailing credit in the face of global deleveraging—there was monetary easing as interest rates were cut dramatically, liquidity provision was stepped up, limits to deposit insurance were expanded, and special credit lines were set up for use by troubled banks. The size of governments expanded overnight. First, several crisis-affected and crisis-prone countries directly supported their financial sectors by injecting funds to recapitalize banks, insurance companies and investment banks, especially those deemed “too big to fail.” For example, the International Monetary Fund (IMF) estimates that advanced G-20 economies spent about 3.5 percent of their GDP on such financial support. Hungary, Poland, and Ukraine took similar steps in providing direct support to the financial sector. Second, as growth slowed in almost all countries, declines in the price of equities, properties, and commodities led to reductions in government revenues and private and public spending. Aggregate demand had to be shored up by fiscal stimulus packages. Third, the losses on funded pension schemes increased governments’ fiscal liabilities. For example, countries in the Eastern and Central Asian region have automatic stabilizers such as unemployment benefits. Fourth, several countries used public resources to bail out their trouP O L I C Y M A K E R S U N D E R S TO O D

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bled industries (for example, General Motors and Chrysler in the U.S. and the French auto industry). Fifth, the governments became “market makers.” However, despite this expansionary fiscal policy, John Taylor’s article details why the U.S. and European governments’ fiscal (and monetary) policies may not work and could actually exacerbate the problem, including prolonging the recession. As a result, public finances have deteriorated in a number of advanced and developing countries, and this has increased fiscal risks and raised premiums for government-issued bonds. Early IMF estimates for advanced economies are that fiscal balances could decline by about 8 percent of GDP between the end of 2007 and the end of 2009, and by 5 percent of GDP in the case of emerging economies. There is likely to be a dramatic increase in public debt levels in both advanced and developing economies. Carmen Reinhart’s paper, in this issue, is based on an historical analysis which concludes that this crisis is essentially no different from past crises and that they always end with deficit, debt, and default. But small open economies such as the Caribbean and Pacific Islands are highly dependent on external economic conditions and on imports. As Dwight Venner’s piece argues, these countries cannot use fiscal stimulus packages to respond to an external shock since their increased spending will fully leak out through higher imports. To date, few countries have taken major steps toward trade protectionism, despite the fact that exports fell by as much as 23 percent in China and other emerging markets. However, some have targeted export firms for subsidies and included protectionist measures in their fiscal stimulus packages. Anne Krueger’s essay makes a strong case for open trade policies, since resumption of global trade is imperative for economic recovery. She argues that with the liquidity crunch, international traders needed more secured means of payment and there is a demand for newer trade-finance instruments than the traditional letters of credit. Moreover, countries have refrained from “beggar-thy-neighbor” competitive exchange rate devaluations to ensure their own exports. Brian Kahn’s essay details the policy mix that was used to stabilize the South African economy. Joseph Stiglitz’s essay focuses on international coordination issues. This is a global crisis and therefore there is a need for collective action, such as the attempts made by the G-20 since November 2008. Fiscal stimulus in the U.S. will not be very effective if the Euro zone countries do not stimulate their economies. When all countries act in concert, the amount of global fiscal stimulus needed is much less, and the world economy will recover much sooner.

What is the outlook for the world economy after one year of meltdown? T H E R E W E R E S O M E S I G N S O F R E C OV E RY or “green shoots” in the U.S. and a few other advanced economies between July and September 2009, but unemployment is still rising in the Western world. After increasing between 2000 and 2007, world output growth slowed down to about 3 percent in 2008 and is projected to decline by 1 percent in 2009. Underlying these averages is the fact that advanced economies, which grew at

about 0.6 percent in 2008, are projected to decline by 3.4 percent in 2009, and begin to show some recovery in the year 2010. The reason for this low performance is that the financial system in the U.S. and Europe has been damaged and the fiscal burden of the economic and financial crisis is quickly mounting. On the other hand, emerging and developing economies are expected to grow at about 6 percent on average in 2009, with China, India, and other Asian countries pulling the world wagon. Conversely, there have been steep declines in output in Central and Eastern Europe, Russia, Mexico, and a few other countries. Vladimir Gligorov’s essay on Southeastern European countries points out that output declines in crisis-affected Eastern European countries may never come back to the trend growth rate. How can countries sustain their economic recovery? There is a need to recover the funds released as bail-outs and to ensure liquidity. Central Banks need to be aware that their balance sheets have expanded because of measures they took to achieve monetary easing, and their debt levels have risen. There is an increased likelihood of a sudden jump in inflation. But policy makers should not be tied too strongly to inflation-targeting and they must learn to better manage asset bubbles. Interest rates have to be increased gradually as the economy gains strength. Asian central banks have to be more prudent in foreign exchange reserve accumulation and move away from currency manipulation. More and more countries are moving to intermediate exchange rate regimes such as managed float, target bands, and basket pegs. On the fiscal side, highest priority should be assigned to bringing down deficits and debt levels that were incurred in fighting the recent recession. Subsidies to large auto industries and financial firms put similar entities in developing countries at a disadvantage. Fiscal discipline has to be reinstated and governments will have to reform health and pension systems. Financial regulations are urgently needed to deal with institutions such as banks, investment banks, insurance, housing-finance entities and so called too-big-to-fail firms. Further, prudential regulations need to be counter-cyclical if they are to be successful in managing credit growth and asset bubbles. In developing countries, a lack of financial intermediation is an underlying cause of global macroeconomic imbalances. For almost a decade, international economic observers have advised that the world economy needs a major adjustment. Sustained global growth requires that the U.S. cut back on its domestic demand and let the dollar depreciate to increase net exports, which will enable the U.S. to improve its current account balances. Conversely, China and other Asian countries should stimulate domestic demand and let their exchange rates appreciate. Such a rebalancing of aggregate demand, away from the U.S. and toward China, would help sustain a global recovery. If this rebalancing does not happen quickly, global growth may be flat. With the U.S. at the epicenter of the financial crisis, countries such as the BRICS (Brazil, Russia, India, China, South Africa) and oil producers holding large foreign exchange reserves primarily in U.S. dollars began to worry about the efficacy of the dollar as the main reserve currency. Barry Eichengreen’s essay discusses why the euro and the yen may find it hard to dislodge the dollar as the reserve currency.

This crisis can prompt a structural transformation that could change the economic history of the world. The developing economies, which together account for about 50 percent of world output, are on the rise and playing a major role in the world recovery. Some of them have the fiscal space to borrow, but the volume of financing they need at fair prices, without crowding out the private sector, may not be available. To address such impediments, the World Bank has set up a new Asset Management Corporation through its private sector wing (the International Finance Corporation) to invest in banks, equity, infrastructure, and development of local currency bond markets, and to facilitate debt restructuring.

Conclusion and could it happen again? National supervision and regulatory systems were inadequate to manage transnational institutions, such as Lehman Brothers, Citibank, AIG, Dexia Bank and others. Consequently, national authorities will have to pay closer attention to risk-taking behaviors, to limit leveraging, tighten capital regulation, attend to liquidity supervision as well as supervision of complex cross-border financial institutions, and to improve transparency of transactions. The crisis has also revealed deficiencies in international coordination such as the IMF’s weak surveillance of advanced economies and its lack of enforcement authority. National and global solutions are needed to regulate capital flows and prevent systemic and global risks by reining in financial firms and conglomerates; to ensure higher international standards for credit rating agencies; and to eliminate inconsistencies in national legal frameworks. There is even talk of creating “a global college of supervisors.” How can we deter another crisis? One way is for central banks not only to keep inflation low but also to manage asset bubbles early on. Rapid growth in credit should be tracked and carefully analyzed to ensure that it is in line with financial development and not fueling asset price increases. Some would prefer that the early warning systems of macro- and micro-prudential indicators be further developed. However, each financial crisis is different and such indicators may not be very useful in predicting a banking or financial crisis because they do not take into account the inter-linkages between credit flows to various sectors and issues of “too-big-to-fail” conglomerates and cross-border financial flows. I S T H E F I N A N C I A L C R I S I S OV E R

Raj Nallari is Lead Economist with the World Bank Institute, Growth and Crisis Unit. Endnote 1 It is estimated that in the United States there were almost 7 million housing loans “under water” and close to default, each loan averaging about $300,000; this totals to $2.1 trillion. In addition, potential defaults on credit card payments, student and car loan payments are estimated to be in the range of about $10-12 trillion. The government could have directly taken over these bad housing loans and loans held potential defaulters but moral hazard (rewarding bad behavior will incentivize even non-defaulters to default on loan payments) can exacerbate the problem.

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The Economic and Fiscal Consequences of Financial Crises North and South BY CARMEN M. REINHART The Ds: Sharp economic downturns follow banking crises; with government revenues falling, fiscal deficits worsen; deficits lead to debt; as debts pile up rating downgrades follow. For the most fortunate countries it does not end in default. S I N C E T H E S U B P R I M E C R I S I S B E G A N to unfold in the summer of 2007 and escalated in the early fall of 2008, a cursory reading of the global financial press would lead to the logical

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conclusion that the world economy is moving through uncharted waters. There is little need to convince anyone that financial crises are associated with economic downturns and severe dislocations in financial markets. In a recent paper with Kenneth S. Rogoff we examined the international experience with episodes of severe banking crises to identify empirical similarities as regards the depth, duration, and characteristics of the economic slump following the crises.1 Our findings in that paper can be summarized as follows:

Financial crises are protracted affairs. Asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years. Equity price collapses average 55 percent over a downturn of about three and a half years. There are profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts four years on average. Real GDP per capita falls (from peak to trough) an average of more than 9 percent, and the duration of the downturn averages roughly two years. The financial crisis has significant adverse consequences for government finances. Tax revenues shrink as the economic conditions deteriorate, the fiscal deficit worsens markedly, and the real value of government debt explodes, rising an average of 86 percent in the major post–World War II episodes. In this article I elaborate on these points and follow up with a sketch of how the crises and their ramifications affected sovereign risk in the aftermath of the crisis episodes.

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The downturn that the present U.S. financial crisis is severe by any metric. As a result, we focus on

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systemic financial crises: the “big five” advanced economy crises (Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992) plus a number of famous emerging market episodes: the 1997–1998 Asian crisis (Hong Kong, Indonesia, Korea, Malaysia, the Philippines, and Thailand); Colombia, 1998; and Argentina 2001. Central to the analysis are historical housing price data, which can be difficult to obtain and are critical for assessing the crisis episode. We also include two earlier historical cases for which we have housing prices, Norway in 1899 and the United States in 1929. Figure 1 looks at the bust phase in housing price cycles surrounding banking crises, including the current episode in the United States and a number of other countries now experiencing banking crises: Austria, Hungary, Iceland, Ireland, Spain, and the United Kingdom. Ongoing crises are in dark shading, past crises are in light shading. The cumulative decline in real housing prices from peak to trough averages 35.5 percent.2 The most severe real housing price declines were experienced by Finland, the Philippines, Colombia and Hong Kong. Their crashes were 50 to 60 percent, measured from peak to trough. The housing price decline experienced by the United States to date during the current episode is already more than twice that registered in the U.S. during the Great Depression. The duration of housing price declines is quite long, averaging roughly six years. As illustrated in Reinhart and Rogoff (2009a), the equity price declines that accompany banking crises are steeper than

FIGURE 1: PAST AND ONGOING REAL HOUSE PRICE CYCLES AND BANKING CRISES: PEAK-TO-TROUGH PRICE DECLINES (LEFT PANEL) AND YEARS DURATION OF DOWNTURN (RIGHT PANEL)

ONGOING

-35.5 percent

PERCENT DECLINE

Austria, 2008 Hungary, 2008 US, 1929 UK, 2007 Iceland, 2007 Malaysia, 1997 Thailand, 1997 Korea, 1997 Ireland, 2007 Norway, 1899 Argentina, 2001 US, 2007 Sweden, 1991 Spain, 1977 Historical Average Japan, 1992 Norway, 1987 Indonesia, 1997 Finland, 1991 Colombia, 1998 Philippines, 1997 Hong Kong, 1997

6 years

DURATION IN YEARS

Sources: Reinhart and Rogoff (2009a).

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FIGURE 2: PAST UNEMPLOYMENT CYCLES AND BANKING CRISES: TROUGH-TO-PEAK PERCENT INCREASE IN THE UNEMPLOYMENT RATE (LEFT PANEL) AND YEARS DURATION OF DOWNTURN (RIGHT PANEL)

Malaysia, 1997 Indonesia, 1997 Japan, 1992 Thailand, 1997 Philippines, 1997 US, 2007 Hong Kong, 1997 Norway, 1987 Korea, 1997 Argentina, 2001 Historical Average Sweden, 1991 Spain, 1977

7 percent

4.8 years

Colombia, 1998 Finland, 1991 US, 1929 0

PERCENT INCREASE

DURATION IN YEARS

Sources: Reinhart and Rogoff (2009a).

TABLE 1: FISCAL DEFICITS COUNTRY

Years before the crisis

Peak deficit (year)

Increase (-decrease) in the fiscal deficit

CENTRAL GOVERNMENT BALANCE/GDP Argentina, 2001 Chile, 1980

-2.4

-11.9 (2002)

9.5

4.8

-3.2 (1985)

8.0

-3.6

-7.4 (1999)

3.8

Finland, 1991

1.0

-10.8 (1994)

11.8

Indonesia ,1997

2.1

-3.7 (2001)

5.8

-0.7

-8.7 (1999)

9.4

Korea, 19972003 Source: WHO

0.0

-4.8 (1998)

4.8

Colombia, 1998

Japan, 1992

Malaysia, 1997

0.7

-5.8 (2000)

6.5

Mexico, 1994

0.3

-2.3 (1998)

2.6

Norway, 1987

5.7

-2.5 (1992)

7.9

-3.9

-3.1 (1977)

-0.8

Sweden, 1991

3.8

-11.6 (1993)

15.4

Thailand, 1997

2.3

-3.5 (1999)

5.8

Spain, 1977

Source: Reinhart and Rogoff (2009b). *Spain was the only country in our sample to show an increase (modest) in per capita GDP growth during the post-crisis period.

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housing price declines, if somewhat shorter lived. The average historical decline in equity prices is 55.9 percent, with the downturn phase of the cycle lasting 3.4 years. Notably, during the current cycle, Iceland and Austria have already experienced peak-to-trough equity price declines far exceeding the average of the historical comparison group. Figure 2 shows increases in unemployment rates across the historical episodes. On average, unemployment rises for almost five years, with an increase in the unemployment rate of about 7 percentage points. None of the postwar episodes rivals the rise in unemployment of over 20 percentage points experienced by the United States during the Great Depression. Although Figure 2 indicates that the emerging markets, particularly those in Asia, have done better in terms of unemployment than the advanced economies (Figure 2), there are well-known data issues in com-

market economies is that they are more affected by abrupt reversals in the availability of foreign credit. When foreign capital comes to a “sudden stop,” to use the phrase coined by Guillermo Calvo, economic activity heads into a tailspin.3 The cycle from peak to trough in GDP is much shorter, two years.

FIGURE 3: CUMULATIVE INCREASE IN REAL PUBLIC DEBT IN THE THREE YEARS FOLLOWING THE BANKING CRISIS

Malaysia, 1997 Mexico, 1994 Japan, 1992 Japan, 1992 Philippines, 1997 Korea, 1997 Sweden, 1991 Thailand, 1997 Historical Average Spain, 1977 Indonesia, 1997 Chile, 1980 Finland, 1991 Colombia, 1998

Index=100 in year of crisis

Deficits 186.3 (an 86 percent increase)

DECLINING REVENUES AND HIGHER E X P E N D I T U R E S owing to a combina-

150

100

300

250

200

tion of bailout costs and higher transfer payments and debt servicing costs have led to a rapid and marked worsening in the fiscal balance. The episodes of Finland and Sweden stand out in this regard, as the latter went from a pre-crisis surplus of nearly 4 percent of GDP to a whopping 15 percent deficit-to-GDP ratio.

PERCENT INCREASE Sources: Reinhart and Rogoff (2008b) and sources cited therein.

Debt

paring unemployment rates across countries. Widespread “underemployment” in many emerging markets and the vast informal sector are not captured in the official unemployment statistics. As to real per capita GDP, the average magnitude of the decline is 9.3 percent. The declines in real GDP are smaller for advanced economies than for emerging markets. A probable explanation for the more severe contractions in emerging

F I G U R E 3 S H OWS T H E R I S E in real government debt in the three years following a banking crisis. The deterioration in government finances is striking, with an average debt rise of over 86 percent. We use the percentage increase in debt, rather than debt-to-GDP, because steep output drops sometimes complicate interpretation of debt–GDP ratios. As

FIGURE 4: INSTITUTIONAL INVESTOR (II) SOVEREIGN RATINGS CYCLES AND BANKING CRISES: PEAK-TO-TROUGH INDEX DECLINES (LEFT PANEL) AND YEARS DURATION OF DOWNTURN (RIGHT PANEL)

Chile, 1980 Argentina, 2001 Indonesia, 1997 Malaysia, 1997 Korea, 1997 Thailand, 1997 Average Colombia, 1998 Finland, 1991 Japan, 1992 Norway, 1987 Sweden, 1991 Hong Kong, 1997 Mexico

-15.1

Default/restructuring Near-default/bailout

-35

-30

-25

-20

-15

-10

-5

PERCENT DECLINE

5.1 years

DURATION IN YEARS

Notes: II ratings range from 0 to a 100, rising with increased creditworthiness.

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Reinhart and Rogoff (2009b) note, the huge buildups in government debt are driven mainly by sharp falloffs in tax revenue. The much publicized bank bailout costs are typically second order. Fiscal stimulus also adds to the deficits in advanced and emerging market economies.4

emerging market sovereign defaults since World War II took place at levels of debt below 60 percent and would have satisfied the Maastricht criteria.6 Debt intolerance applies to both external and domestic debt. Carmen M. Reinhart is Professor of Economics at the University of

Downgrades (sometimes default) A S S H OW N I N F I G U R E 4

(on the previous page), sovereign default, debt restructuring, or near defaults (prevented by international bailout packages) have been a part of the financial crisis experience in many emerging markets, therefore a decline in the country rating hardly comes as a surprise. Advanced economies, however, do not go unscathed Finland’s score went from 79 to 69 in the space of three years, placing it close to the scores for some of the emerging markets!

Conclusions and implications for emerging economies

Maryland. References Ilzetzki, Ethan, Enrique Mendoza and Carlos Vegh, “How big (small) are fiscal multipliers?” Mimeograph, University of Maryland. College Park, June 2009. Reinhart, Carmen M. and Kenneth S. Rogoff , “The Aftermath of Financial Crises,” American Economic Review, Vol. 99 No. 2, May 2009a, 466-472. Reinhart, Carmen M. and Kenneth S. Rogoff , “Banking Crises: An Equal Opportunity Menace,” NBER Working Paper 14587, December 2008. CEPR Working Paper 7131, January 2009b. Reinhart, Carmen M., Kenneth S. Rogoff and Miguel A. Savastano, “Debt Intolerance,” Brookings Papers on Economic Activity, Vol.1 Spring 2003, 1-74 Endnotes 1 “The Aftermath of Financial Crises,” (with Kenneth S. Rogoff), American Economic Review, forthcoming, May 2009. http://terpconnect.umd.edu/~creinhar/Papers.html

A N E XA M I N AT I O N of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output, and 2 The historical average, which is shaded in black in the diagram, does not employment. Unemployment rises and housing price declines include the ongoing crises. extend out for five and six years, respectively. The recessions 3 See Calvo, Izquierdo and Loo-Kung (2006). are almost invariably accompanied by massive increases in 4 While, historically, stimulus packages have not been as large in emerging government debt. The crises adversely impact sovereign credmarket economies as in advanced economies, fiscal multipliers also appear itworthiness, as reflected in higher risk premia. to be smaller for the former. Ilzetzki, Mendoza and Vegh (2009) show that The global nature of the present crisis will make it far more while fiscal multipliers are roughly of the same order of magnitude in difficult for many countries to grow their way out through advanced and developing economies on impact, they erode much more increased exports. The growth slowdown is amplified in world quickly in emerging markets. commodity markets, as many emerging markets face steep 5 Reinhart and Rogoff (2009b). declines in their terms of trade. 6 See Reinhart, Rogoff and Savastano (2003). If historical patterns hold, showing a link between banking and debt crises the current lull in sovereign defaults or restructurings in emerging markets will likely come to an end, particularly if the recovery process in the world’s largest economies is delayed.5 With the advanced economies’ running large government deficits that are accompanied by a rapid rise in government debt, emerging markets will find external private financing less available—this is the global dimension of crowding out. Emerging markets will therefore rely more on the multilateral institutions for external funds and on domestic debt. It is important for policymakers in these countries to remember that “fiscal space” is limited, that their scope for sustained stimulus packages financed by debt is capped by their low thresholds for debt (at least An apartment for sale in St. Petersburg, Russia. historically). More than one half of

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SPECIAL REPORT

Shock Producers and Shock Absorbers in the Crisis BY HANS-WERNER SINN

After the bubble burst in the United States (U.S.). Since about 1980 the savings rate of U.S. households had fallen from about 10 percent to nearly zero and, because households did not save, the U.S. had to import gigantic amounts of capital from the rest of the world to finance its investments and government budget deficit. Capital imports amounted to 790 billion dollars in 2008. One of the reasons for the decline in savings rates was that the U.S. financial system generously provided mortgages to homeowners, which often was tantamount to hidden consumer credit. The excess of new mortgages over housing investment approached 60 percent in the years before the crisis. Homeowners and banks had jointly speculated on increasing house prices. On top of that, the government with its Community Reinvestment Act had forced banks to lend even to the poorer segments of the population.

T H E C R I S I S O R I G I N AT E D

house values declined by a third by April 2009, which was a decline in wealth in the order of 6 trillion dollars. The decline in home values was followed by a worldwide decline in other asset values of about 50 trillion dollars because of secondary effects. This has sent shock waves through the U.S. and the rest of the world via three main channels. The first and most important channel was the decline in construction in the U.S., following the decline in the sale of new homes: 75 percent by April 2009. The second was a decline in worldwide consumption because of the wealth effect and the increase in unemployment. The third was a credit crunch resulting from the fact that huge equity losses had forced banks to scale down their lending and investment operations so as to avoid violating the supervisory minimum

A FT E R T H E B U B B L E B U R S T,

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debt-equity ratios. The U.S. banking system alone had lost 53 percent of its equity stock by February 2009. The shock waves of the bursting bubble were then mitigated through extensive bank rescue packages in the order of 4.1 trillion euros and Keynesian counter-cyclical budgetary effects in the order of 1.1 trillion euros. The budgetary effects came through discretionary measures as well as through the built-in flexibility of the national tax-expenditure systems. Figure 1 shows the changes in the deficit/GDP ratios from 2008 to 2009 for the OECD countries and thus measures the respective countriesâ€™ Keynesian stimuli to counteract the world recession.

Fiscal stimuli W H I L E S M A L L E R C O U N T R I E S like Norway, Australia, Sweden, or Denmark are among the countries that have exerted the proportionally largest fiscal stimuli, the U.K. is the outperformer among the big countries with a 7.3 percentage point increase in the deficit share in GDP. On average, the OECD countries have increased their deficit share by 4.5 points, and the euro area has increased its own by 3.7 points. At 4.3

points, the U.S. comes close to the OECD average, and at 3.6 points Germany comes close to the Euroland average. Among the big European countries, France and Italy lag a bit behind with 3.3 and 2.6 points respectively. In the winter months some international irritation was caused by U.S. officials and scholars accusing Germany of not providing sufficient Keynesian stimuli against the crisis. The data show that there may have been some foundation for this allegation. However, the differences are not particularly large. While it is true, for example, that the U.S. has taken more substantial discretionary measures than Germany, the built-in flexibility of one of the worldâ€™s largest welfare states has provided an automatic stabilization effect that must also be taken into account. Still, as is shown in Figure 1, the overall U.S. fiscal stimulus was somewhat bigger.

Trade balances H OW E V E R , T H I S I S N AT U R A L since the crisis originated in the U.S. and not in Europe. A more important question for an overall assessment of the situation is, therefore, how large the

FIGURE 1: CHANGES IN GOVERNMENT DEFICIT/GDP SHARES 2008-2009, OECD COUNTRIES, PERCENTAGE POINTS

Source: OECD Economic Outlook 85 database; calculations by the Ifo Institute.

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net demand shocks exerted by various countries really were for the rest of the world . This is answered in Figure 2 for a number of countries for which data could be found, including the BRIC countries (Brazil, Russia, India, and China). The graph shows the changes in the respective trade balances from the first quarter 2008 to the first quarter 2009 and hence the net reductions in aggregate demand that were exerted from the respective country to the rest of the world. It is not surprising that the U.S. has been by far the world’s largest shock producer in this crisis. While both its exports and imports fell, its annualized imports shrank by 361 billion dollars more than its exports. More surprising is that China did not reduce its huge trade surplus but increased it even further. Its imports declined by 71 billion dollars more than its exports. China amplified the shockwave coming from the U.S., and so did Brazil, Spain, the U.K., and South Korea, among others.

Shock absorbers on the other hand were Japan, Russia, and Germany, whose exports all shrank more than their imports: by 110 billion, 124 billon and 168 billion dollars

THE BIG SHOCK ABSORBERS

respectively. This exonerates Germany from the accusations of free riding in the current crisis. Germany is currently the world’s biggest shock absorber. The reason for this result is that the German economy is still surprisingly stable internally. The welfare state has many allocative disadvantages in the long run, but in a crisis it has a cushioning effect: 42 percent of adult Germans live on government transfers including state pensions, and the government pays short-term work insurance for up to 24 months to employers who keep their employees working at reduced hours during the crisis. Moreover, Germany has had no housing bubble, and its mortgage system is particularly safe and stable. Germany has long-term fixed interest loans, extremely tight credit constraints for home owners (loans rarely exceed 60 percent of a home’s value), and double-secured, mortgage-backed securities (Pfandbriefe) that give buyers direct claims against the banks rather than only against the homeowners. The world has benefitted from this stability. Hans-Werner Sinn holds the Economics and Public Finance Chair at the University of Munich and is President of the Ifo Institute for Economic Research.

FIGURE 2: CHANGE IN ANNUALIZED TRADE BALANCES1), FROM Q1 2008 TO Q1 2009, IN BILLION US DOLLARS2)

1) Trade in goods, seasonally adjusted and annualized figures. 2) January and February 2009 against January and February 2008. Source: OECD; calculations by the Ifo Institute.

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SPECIAL REPORT

The Crisis and the World’s Poorest BY MARTIN RAVALLION has spilled over into the lives of the world’s poorest. Because of the crisis, poverty is higher in most developing countries, although the impact is greater in some countries than in others, due to differences in their dependence on foreign trade, investment and remittances. Differences in pre-crisis savings rates and in the accumulation of foreign reserves also mean that some countries are facing more severe fiscal adjustment problems than others. While some countries have had scope for a fiscal stimulus, others have not. The effects are certainly not confined to the poorest, and not all of the poor will be affected. Indeed, some are being protected by the same factors that have kept them poor—geographic isolation and poor connectivity with national and global markets. However, the poorest can be particularly vul-

T H E C R I S I S I N T H E D E V E L O P E D WO R L D

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nerable even to seemingly small income shocks. For example, productive activity is simply not feasible at low levels of nutrition; this “threshold effect” means that a negative shock of sufficient size can push a poor household past its tipping point and put it on a path to destitution. Research has shown that past crises have left lasting effects. A study of the longer-term impacts of the East Asia crisis found that about half of Indonesia’s poverty count in 2002 was attributable to the 1998 crisis even though macroeconomic recovery had been achieved well before 2002.1 Many of the actions poor families have to take to help protect their current living conditions have lasting consequences. Debts rise; key productive assets (such as livestock or land) are sold. And kids are taken out of school to save money and add to the family’s current earnings. When poor families are compelled to cut short their children’s schooling in response to a shock, this creates a lasting

impact on poverty since school drop-outs tend to earn less as adults. This impact will vary, depending on the extent of the shock and initial conditions. Declining wages make child labor relatively less attractive, and schooling more so; but, at the same time, lower parental incomes increase the value of the extra money that children can bring to the family budget if they work. The balance of these forces varies from place to place. There is evidence that in low income countries schooling tends to decline in a macroeconomic or agro-climatic crisis while in middle- and higher-income countries school attendance increases.2 Impacts on the nutritional status of young children in poor families are also of special concern, since poor nutrition in the early years of life retards child growth, cognitive and learning ability, schooling attainments and, in all likelihood, earnings in adulthood.

be in South Asia; 10 million will be added to the poverty count in East Asia and 7 million in Sub-Saharan Africa. Another 64 million will be added to the number of people living under $2 a day. Given the current growth projections for 2010, there will be a further increase in poverty in that year, with a cumulative increase of 89 million people living under $1.25 a day and 120 million more under $2 a day by 2010. Of course, aggregate poverty measures cannot tell the whole story. There will also be impacts on non-income dimensions of welfare. Colleagues in the Bank’s research department estimate that the crisis will lead to 30-50,000 excess deaths amongst infants in Sub-Saharan Africa this year; these will be disproportionately girls.5

Expected impacts on aggregate poverty

short-term relief against the need for rapid recovery. Restoring economic growth will be crucial to recovery for the world’s poorest. Protecting the poorest through social assistance need not entail a trade off against growth. Indeed, it can be argued that to help restore growth, domestic stimulus efforts and external assistance should favor poor people; and any required fiscal adjustments should minimize negative impacts on the poor. A pro-poor stimulus is likely to be more effective because poor people tend to be more financially constrained—notably due to credit market failures—and so are most likely to engage in rapid consumption or investment when extra cash becomes available. However, experience has been mixed. Crises have given birth to some of the worst “social protection” policies, as well as some of the best. Governments have sometimes been drawn into introducing generalized food and fuel subsidies that have come at a huge fiscal and economic cost, are not easily reversed, and have had at best modest impact on poverty. Yet some developing countries have been able to turn a crisis into an opportunity for dismantling inefficient subsidies in favor of more effective safety-net programs. Relief work (“workfare”) is likely to be an important element of an effective social policy response. But design is crucial: a well-designed workfare scheme has built-in features that encourage only those in need of help to seek out the program and encourage them to drop out of it when help is no longer needed given better options in the rest of the economy. A famous example is the Employment Guarantee Scheme (EGS) in Maharashtra, India, which started in the early 1970s in response to the threat of famine. The EGS aims to assure income support in rural areas by providing unskilled manual labor at low wages to anyone who wants it. The employment guarantee is a novel feature of the EGS, which helps support the social insurance function, and also helps empower poor people. In 2004, India introduced an ambitious national version of this scheme under the National Rural Employment Guarantee Act. This promises to provide up to 100 days of unskilled manual labor per family per year, at the statutory minimum wage rate for agricultural labor, to anyone who wants it in rural India. The scheme was rolled out in phases and gained national coverage—just in time to help cushion the

P OV E RT Y C O U N T S R E Q U I R E H O U S E H O L D S U RV E YS , which will not be available for some time. Given these lags, we must rely for now on projections. Before the crisis, the incidence of poverty in the developing was on a trend decline. The proportion of the developing world’s population living under $1.25 a day in 2005 prices fell from 52 percent in 1981 to 25 percent in 2005; that implies 500 million fewer poor by this standard (from 1.9 billion in 1981 to 1.4 billion in 2005).3 This trend would have almost certainly continued in the absence of the crisis. To assess the impact of the crisis we need to estimate the difference between the expected level of poverty, given the crisis, and what we would have expected based on the pre-crisis trajectories. The poverty impact of the crisis in a given country will depend on how it affects both average consumption and the distribution of consumption relative to the mean. The World Bank’s Development Prospects Group has made projections for average consumption at the country level after the crisis. These can be compared to the Bank’s pre-crisis projections to assess the expected impact of the crisis. At the time of writing (mid-June 2009), we expect the crisis to knock almost 5 percentage points off the consumption growth rate for 2009, bringing it down to zero. The effects on growth impacts will tend to be greater in less poor countries. (Eastern Europe and Central Asia figure prominently in this group). This pattern will help dampen the overall impact of the crisis on poverty. What about the distributional effects within countries? Experience suggests that relative inequality falls about as often as it rises during aggregate economic contractions, with zero change on average. So the most defensible assumption for estimating the effect on aggregate poverty is that the burden of the crisis will be more-or-less proportional to initial income. However, while this is plausible in the aggregate, distributional impacts can be expected in individual countries, with inequality rising in some and falling in others. Applying country-specific growth projections to surveybased data and aggregating them, we estimate that the crisis will increase the 2009 count of people living below $1.25 a day by 50 million.4 More than half of this increase is expected to

Social policy responses6 CRISIS RESPONSES NEED TO BALANCE

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impact of both the crisis and the drought that hit many areas of the country this year. An ideal workfare scheme will guarantee low wage work on community-initiated projects. The low wage rate ensures that the scheme is self-targeted in that the non-poor will rarely want to participate, and those needing relief during the crisis will voluntarily leave once recovery is underway. The federal or state government announces that it is willing to finance up to, say, 15 days of work a month on worthwhile community projects for any adult at a wage rate no higher than the market rate for unskilled manual labor in a normal year. The work is available to any adult at any time, crisis or not. As long as the guarantee is credible it will also help reduce the longer-term costs of risk facing the poor. Thus a well designed and implemented scheme of this sort it can help in fighting chronic poverty as well as transient poverty in a crisis. Relief work will need to be supplemented by transfers, in cash or food, targeted to specific groups of people who either cannot work due to physical incapacity, including poor nutritional status, or should not be taken out of other activities, notably school. A recently popular class of transfer programs requires the children of the recipient family to demonstrate adequate school attendance, and health care in some versions. Early influential examples were Bangladesh’s Food-forEducation Program, Mexico’s PROGRESA program (now called Oportunidades) and Bolsa Escola in Brazil. Such programs aim to strike a balance between reducing current poverty (through the transfers) and reducing future poverty (through the behavioral responses). In a crisis, the largest benefits from such programs may well be found in the poorest countries, where the income effect on schooling will probably dominate. Targeting the transfers made as part of a fiscal stimulus to women in poor families can also improve the terms of the trade-off between current and future poverty reduction, notably by assuring that children benefit more. Experience with such programs suggests that it should be possible to protect a significant share of the world’s poorest in a crisis. And with careful policy design, this can be done without damaging the longer-term prospects of escaping poverty, and even enhancing them.

These are the views of the author and need not reflect those of the Bank, affiliated organizations or member countries.

Endnotes 1 See Martin Ravallion and Michael Lokshin, “Lasting Impacts of Indonesia’s Financial Crisis,” Economic Development and Cultural Change 56(1), 2007, pp. 27-56. 2 See Francisco Ferreira and Norbert Schady, “Aggregate Economic Shocks, Child Schooling and Child Health.” Policy Research Working Paper 4701, World Bank, Washington DC., 2008. 3 The average poverty line for the world’s poorest countries is $1.25 a day in 2005 prices at purchasing power parity, while the average line for all developing countries is $2.00 a day; see Martin Ravallion, Shaohua Chen and Prem Sangraula, “Dollar a Day Revisited,” World Bank Economic Review. 23(2), 2009, pp. 163-184. 4 Shaohua Chen and I have used the latest growth projections for 2009 and 2010 (as of mid-June 2009) as the “post-crisis” growth rates while the counterfactual (pre-crisis) projections for those done by the Bank in December 2007 for 2009 and 2010. We have used the growth projections for private consumption per capita. (Consumption is more appropriate than GDP for predicting the short-term impacts on poverty, since the shock to GDP is unlikely to be passed on fully to consumption in the short term.) See Shaohua Chen and Martin Ravallion, “The Impact of the Global Financial Crisis on the World’s Poorest,” for further detail on the assumptions and methods. 5 See Jed Friedman and Norbert Shady, “How Many More Infants are Likely to Die in Africa as a Result of the Global Financial Crisis?” Policy Research Working Paper, World Bank. 6 For a fuller discussion of the issues raised in this section see Martin Ravallion, “Bailing out the World’s Poorest,” Challenge 52( 2), 2009, pp. 55-80.

Martin Ravallion is Director of the World Bank’s Research Department, the Development Research Group.

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SPECIAL REPORT

Growth is Disappearing and May Not Recover in the Medium Run BY VLADIMIR GLIGOROV C O U N T R I E S I N T R A N S I T I O N in Central, Eastern, and South Eastern Europe (CESE) have been hit hard by the global crisis. Though there was some stabilization at the turn of the first to second quarter of this year (2009), the risks of further deterioration in some of the countries are still quite high (Gligorov, Poeschl, and Richter 2009). These risks are mainly connected with the stability of the financial sector, with falling public revenues, and with slow revival of demand in the European Union which is the principal market for CESE exports. There is also a need to rethink the growth model because a return to

the status quo ante does not seem realistic, at least not in the medium term.

Integration and contagion M O S T O F T H E C E S E E C O N O M I E S are small, open, and quite integrated with the European Union (EU). These include the so called New Member States (NMS) that joined the EU in 2004 and 2007, two of which have recently entered the euro area (Slovenia and Slovakia), as well as the countries in Southeast Europe that have yet to join the EU (so called Future Member States, FMS, or candidate and potential candidate countries,

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which include Turkey). Countries farther to the east, for example, Ukraine, Belarus, and in particular Russia are either larger countries or less integrated with the EU or both. Integration has been a mechanism of both propagation and mitigation of crisis. Because of the high level of trade integration, the crisis has led to a sharp decline in both exports and imports. In addition, financial integration is a source of instability, even though their domestic financial sectors may be sound. Thus, countries that are more integrated with the EU have suffered more from the crisis. On the other hand, these countries are also better positioned to profit from the various measures introduced in the EU to support stability and spur recovery. As long as these measures stimulate trade and stabilize the financial system that has positive consequences for the more integrated CESE countries because it supports their exports to the EU markets. A more fundamental problem of deep integration is that it leads to a strategy of growth that implies high and persistent external imbalances: the main indicator being the current account deficit. This could be called a neoclassical growth model. In the initial phases, foreign investments rush in to profit from high productivity growth in capital scarce economies and, later on, exports increase sufficiently to cover the trade deficits: in the process, there is convergence growth, that is, when growth in less developed countries is faster than in the more developed ones. The real and nominal exchange rates adjust, basically appreciate, in order to support that process. In the end, the remaining current account deficit reflects the income balance, where the profits and dividends of the foreign investors are recorded. Countries in transition can be classified by the stage in which they find themselves in this process. Roughly, EU member states (NMS) have mostly balanced trade by now

(though not the income account), while countries to the southeast (FMS) have more pronounced, or very pronounced, trade deficits. Countries farther to the east are less integrated and also depend more on export specializationâ€”they export mainly oil, gas, metals, and raw materialsâ€”and thus have different balance of payments structures reflecting a somewhat different model of growth and development. In the group of countries with current account deficits, the lack of demand for their exports and the declining availability of foreign financing work together to produce sharp and in some cases disastrous recessions. Negative growth rates vary between minus almost 20 percent in some of the Baltic countries to minus 1 percent in some Balkan countries (Poland being an exception with close to 1 percent growth so far this year). Overall, more open countries (in terms of the exports to GDP ratio) with trade and income account deficits, such as the Baltic countries, are doing worse, while more closed economies such as Poland, with less of a deficit in their income accounts (for example, the FMS), are experiencing milder recessions. On the other hand, economies that are more open are better placed to benefit from fiscal and other measures that are supportive of trade and may also have more stable, though not risk-free, financial systems.

Risks and sustainability

and fiscal policies account for much of the change in risks and in the assessment of sustainability of macroeconomic balances. Given that the main vulnerability is the external imbalance, the adjustments of the exchange rates have to be expected, as are the limitations on the activism of fiscal policy, because widening fiscal deficits can spill over into higher imports. The risks to the stability of exchange rates are significant, though the general direction for countries with current account deficits is one of exchange rate depreciation. However, the distribution of risks depends to a large extent on the exchange rate regime: countries using the euro, those with fixed exchange rates and those with flexible rates have different financial and real consequences. In general, countries with flexible exchange rates have seen sharp nominal devaluations, which have also led to weaker but still significant real exchange rate devaluations (for example, Poland, the Czech Republic, Hungary, Romania, Serbia, and Turkey). This has had some cushioning effect for the tradable and the real sectors generally, but in certain cases has increased In Budapest, Hungary, construction work has slowed down as a consequence of the financial crisis. financial risks (for example,

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E XC H A N G E R AT E R E G I M E S

Hungary, Romania, and Serbia). Countries with fixed exchange rates, on the other hand, have struggled to stabilize their financial sector, with increasing risks in the real sector in some cases (for example, Baltic countries and Croatia). In these cases, real exchange rate adjustment has to come about through deflation which introduces huge risks in the real economy. Finally, economies that are inside the euro area (Slovakia and Slovenia) or that use the euro (for example, Montenegro and Kosovo) have additional difficulties to engineer real exchange rate adjustments because they tend to resort to fiscal stimuli which, although they work against the deflationary tendencies, put their tradable sectors at risk. Thus, to the extent that the financial sector has been stabilized for the moment, the remaining risk has to do with the adjustment of the real economy, which may prove to be rather more difficult in those countries with fixed exchange rates (or hard pegs, for example, currency boards) in the short run, due to the problems that deflation brings, and rather more difficult for countries using the euro in the medium run, due to loss of competiveness. Countries with flexible exchange rates, however, may run into liquidity problems in the short run, because of worsening balance sheets in the financial, household and the corporate sectors, but should be in a better position to take advantage of the increase in external demand in the medium run. In some countries, monetary policy is not completely impotent, though only Russia has enough room to manoeuvre. When it comes to fiscal policy, however, some countries are in a better position than others. In general, transition economies have had relatively lax fiscal constraints in the last decade or so because of their high growth rates. So, even with persistent fiscal deficits, debt to GDP ratios tended to decline. This was also supported by declining interest rates. Thus, irrespective of fiscal deficits, sustainability of fiscal balances was not an issue: the real limitation on fiscal expansion was the sustainability of the current account because of the steady accumulation of foreign debt, mostly by the private sector. Because credit was readily available at affordable prices, many countries ran pro-cyclical fiscal policies even in the face of rising current account deficits and surging private debt. As a consequence, fiscal policies in the crisis have also had to be pro-cyclical and fiscal positions in many cases now seem unsustainable: with rising interest rates, rising fiscal deficits, and worsening growth prospects, public debt to GDP ratios tend to increase without limit. Sustainability of fiscal balances does not look much better even in countries with quite low levels of public debt, for example, the Baltic countries. This is because credit has dried up, depression has set in, and fiscal risks have increased very rapidly. These countries are trying to cut public expenditures dramatically, but if that leads to mass bankruptcies in the household and the corporate sectors, public obligations will shoot up immediately and fiscal balances will be unsustainable. This is what is meant by fiscal risks. A minority of countries have stuck to countercyclical policies and so can resort to fiscal stimuli in times of crisis. These include, for example, the countries in the euro area, as well as Bulgaria, the Czech

Republic and Montenegro, Russia, and some other oilexporting countries. But overall, fiscal expansion is not an option because of growing risks to exchange rates, nominal or real, and unsustainable fiscal balances.

Savings and exports I F T H E P R O C E S S O F D E L E V E R AG I N G C O N T I N U E S for some time, the possibility of going back to the neoclassical model of growth may be called into question. If foreign financing remains unavailable or expensive, what is the alternative model of growth? Clearly, domestic savings will have to increase. At the moment, trade deficits are shrinking fast as are current account deficits. Although this is mostly the consequence of the decline in consumption, it is not altogether clear that savings are increasing, which would have to happen for investments to increase as well. Finally, growth will have to be supported by exports and by the expansion of the tradable sector in general. The latter depends on the recovery of demand in the EU, which will take some time. Growth based on domestic demand is possible in larger countries like Russia, Ukraine or Poland, but smaller economies cannot normally rely on domestic markets. In that context, adjustment of the real exchange rate is crucial, as mentioned earlier in this article. There are, however, some limitations on the growth of savings. Most countries in transition are demographically quite old and employment rates are relatively low (European Commission 2009). In addition, public sector and social security reforms have not led to significant increases in savings rates. An increase in public savings does not seem realistic, while private savings increases are limited. Finally, profitability has declined and it may take some time before it improves; thus incentives to invest will be weak. As a consequence, there are significant risks that the recovery will take some time and growth will be weak in the medium run: in some cases, prolonged stagnation is a distinct possibility.

Social and political risks are democracies, so risks to political stability are relatively low; and EU membership as well as the EU accession process also have a stabilizing effect. Countries that are less integrated and less democratized may experience more political instability. Social unrest has been rather rare in the last twenty years or so, in part because labor unions tend to be weak. Currently, however, populism is on the rise, and may change the political landscape in the medium run. There are two risks to overall stability (more in Gligorov et al. 2009). The first is that financial systems may yet collapse, which would have significant social and political consequences. The MOST OF THE COUNTRIES IN TRANSITION

G r ow t h i s D i s a p p e a r i n g continued on page 24

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SPECIAL REPORT

South Africa’s Policy May Offset the Financial Downturn BY BRIAN KAHN during 2008, it initially appeared as if South Africa, along with other emerging market economies, would be relatively unaffected. South Africa’s banking system was only marginally exposed to the subprime assets that initiated the crisis, and commodity prices accelerated during the first half of the year. The U.S. dollar prices of South Africa’s commodity exports increased by some 26 percent between December 2007 and June 2008, while the domestic equities market reached an historic high in late May of that year. Initially the most significant direct impact of the global financial markets crisis on domestic markets was a 36 percent decline of the financial sector index on the domestic

AS THE GLOBAL CRISIS UNFOLDED

equities market between November 2007 and July 2008. The decoupling hypothesis—that emerging markets in general were no longer intricately tied to the fortunes of the advanced economies—appeared to have some validity. During 2008 the domestic economy was beginning to show signs of moderating, after 5 years of growth of some 5 percent or more. Consensus forecasts at the time indicated that growth was expected to average around 3.5 percent in 2008 and 2009, before returning to rates of around 5 percent in 2010. This slow-down was due in part to emerging electricity supply constraints and a tightening of South Africa’s monetary policy stance. The repo rate had been increased by 500 basis points between July 2006 and June 2008 in response to a higher inflation trend induced by sustained above-potential growth, real

COSATU (Confederation of South African Trade Unions) members march through the streets of Durban to protest against food, electricity and fuel hikes.

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household consumption expenditure growth of around 9 percent in 2006, and higher oil and food prices. The higher expenditure brought about a widening of the deficit on the current account of the balance of payments which had reached a level in excess in 7 percent of GDP in 2007 and 2008. These deficits were financed primarily through portfolio capital inflows. A prudent and conservative fiscal policy was also being implemented, and in the 2008 budget, modest surpluses were budgeted for the next three fiscal years. The public sector borrowing requirement was projected to increase from a small surplus to a deficit of 1.4 percent of GDP in 2010/11. The situation and outlook changed dramatically after September 2008 in the wake of the demise of Lehman Brothers. The collapse of global confidence led to a flight of capital from emerging markets, a dramatic decline in commodity prices, and plummeting demand for exports from emerging markets. South Africa was not spared. Its relatively diversified export market and product base were insufficient to shield the economy from the fall-out of this synchronized global downturn. The effect was quickly felt in the financial markets. From its peak in May 2008, the domestic equities markets lost 36 percent in value by the end of the year, and 22 percent from mid-September. The commodity price index of South Africaâ€™s exports declined by over 30 percent by October compared with its June levels, although the terms-of-trade blow was cushioned to some extent by the fall in international oil prices and the resilient gold price. Portfolio capital flows turned sharply negative in the fourth quarter of 2008, although the overall financial account remained positive, partly as a result of repatriation of foreign currency balances held abroad by domestic banks. Not surprisingly, these developments had an impact on the rand exchange rate which became highly volatile and depreciated from a level of around R8.00 against the U.S. dollar in September 2008 to a low of around R11.80 in November. However by December it had settled down at a level of around R10 to the U.S. dollar. Because of the limited exposure of the economy to foreign debt, balance sheet effects of these currency movements were relatively limited. These developments were reflected in the sudden and sharp downturn in the domestic real economy. Having grown at quarter-on-quarter seasonally adjusted and annualized rates of 5.0 percent and 0.2 percent in the second and third quarters of 2008 respectively, the economy contracted by 1.8 percent in the fourth quarter of that year, and by 6.4 percent in the first quarter of 2009. The mining and manufacturing sectors of the economy were particularly hard hit: the manufacturing sector recorded negative annualized growth of 22 percent in both the fourth quarter of 2008 and the first quarter of 2009, while the mining sector recorded growth rates of 0.4 percent and -33 percent in these quarters. In the second quarter of 2009 the economy contracted at a rate of 3 per cent, with the manufacturing sector recording a contraction of 11 per cent. The mining sector experienced a turnaround, with a growth rate of 5.5 per cent. Nevertheless the South African economy appears to be lagging behind the recovery in a number of the advanced economies. The effects on employment

were felt in the first quarter of 2009 when 179,000 jobs were lost in the formal nonagricultural sector. Exports of both manufactured goods and primary commodities declined sharply. In the first quarter of 2009, total export values had declined by 21 percent compared to the previous quarter. Fortunately, effective regulation and bank supervision shielded South African banks from direct exposure to the troubled securitized debt market in the U.S., and they remained well capitalized. Furthermore, South African banks are predominantly funded by domestic deposits and not through foreign-held structured products. Consequently, unlike many other central banks, the South African Reserve Bank did not at any time have to respond by injecting additional liquidity into the domestic money market. The domestic interbank market continued to operate smoothly with no anomalies observed in either the volumes or rates of interbank funding. However, some deterioration in asset quality was observed in the course of 2008, which was probably attributable to the monetary policy tightening of the previous period. But impairments increased significantly as the economy contracted. Although there is adequate provision for impaired loans, banks have reacted to the downturn in a pro-cyclical manner by significantly tightening credit criteria to both households and the corporate sector, thereby exacerbating the downturn. Credit markets have therefore been affected by a reduction in both the supply of and demand for credit. Credit extension to the private sector, which was growing at rates of around 28 percent in January 2008, had declined to rates of around 4 percent in June 2009. Overall this represents a decline in real credit extension, although a number of components of credit extension became negative in nominal terms as well. The official policy response was to allow for greater flexibility in the application of monetary and fiscal policies. In December 2008, the Monetary Policy Committee (MPC) of the South African Reserve Bank reduced the repurchase rate by 50 basis points to 11.5 percent. In February the frequency of MPC meetings was increased to monthly, to allow for a more continuous assessment of the rapidly changing situation. The repo rate was reduced further by 100 basis points at the February meeting and at each of the subsequent three meetings. The monetary policy stance was unchanged at the June meeting, but at the August meeting the repo rate was reduced by a further 50 basis points, bringing the total reduction to 500 basis points. These actions were taken even though inflation, which measured 10.3 percent in December 2008, was well above the target range of 3-6 percent. However, the forecasts were for inflation to decline markedly over the next few months, and to return to within the target range by 2010. By July 2009, the inflation rate had declined to 6.9 percent. The MPC maintained a focus on inflation in a forward-looking flexible inflation-targeting framework: although inflation was outside the target the committee was satisfied that it would return to within the target range over a reasonable time horizon. In addition, the widening output gap was seen to impart a high degree of downside risk to the inflation outlook. Nevertheless there were a number of upside risks to the inflation outlook that constrained the monetary policy

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response. Some of the emerging upside risks included high nominal and real wage demands and settlements, a turnaround in the international oil price, stubbornly high food price inflation despite a significant decline in agricultural commodity prices, and high rates of increases in administered prices. These factors also contributed to deteriorating inflation expectations. The monetary policy stimulus was complemented by a contracyclical fiscal policy. South Africa was in the fortunate position of having sufficient fiscal space—a result of past prudence —to use fiscal policy in a manner that would not raise questions about sustainability. It is generally agreed that fiscal stimuli in such circumstances should be reversible, with an emphasis on increasing growth-enhancing capital expenditure. The problem is that capital expenditure takes time to implement and so may not be well-suited for cyclical purposes. It was therefore fortuitous that government had embarked on a large-scale infrastructure expenditure program during the earlier part of the decade (including road and rail infrastructure, telecommunications, and more recently electricity generation), and much of this was coming to fruition at a time when most needed from a cyclical perspective. Government and state-owned enterprise expenditure on infrastructure is expected to average 9.7 percent of GDP over the next three years compared with 4.5 percent of GDP in 2005/06. The public sector borrowing requirement is now expected to increase to 7.5 percent of GDP in 2009/10 before moderating to 5.3 percent by 2011/12. These demands on the capital markets are sustainable because government debt to GDP is currently a modest 22 percent. There was also direct stimulus through the budget. The government had budgeted for a surplus of 0.6 percent for the 2008/09 fiscal year, and with declining tax receipts the outcome was a deficit of 1.2 percent. As a result of the slowing economy and a discretionary fiscal stimulus, a deficit of 3.9 percent of GDP was budgeted for the 2009/10 fiscal year. It is estimated that about half of this increase was due to lower expected tax receipts, implying an expenditure stimulus of some 2 percent of GDP. More recently the minister of finance noted that tax revenues are likely to be somewhat lower than anticipated, and a higher deficit outcome is likely. However the government has projected deficits for the next two financial years to decline to 3.1 and 2.3 percent of GDP respectively. South Africa has not been spared from the impact of the global crisis. However its policy response should to some extent help to contain the contraction. Some internal and external developments indicate that the worst may be over. Portfolio capital inflows have resumed; the rand has appreciated to almost pre-crisis levels; commodity prices have recovered from their lows, although still significantly below their highs of last year; and most leading indicators show that positive growth should be achieved during the latter part of this year. Nevertheless the recovery is likely to be slow and hesitant, and dependent to a significant degree on the nature and speed of the global recovery. Brian Kahn is Head of Research and Policy Development at the South African Reserve Bank.

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G r ow t h i s D i s a p p e a r i n g continued from page 21

level of integration and interconnectedness of the financial system in the EU and in the transition countries would make such a crisis even more devastating then the current one. This is why the International Monetary Fund (IMF) has been called back to support global financial stability—to bail out the banks in effect. It can be expected that many countries in transition will end up with stand-by agreement before this crisis is over. In addition, the IMF is supporting the so-called Vienna Initiative, which is a commitment by the banks in countries that have an IMF program to keep their credit exposure at existing levels, which should help the process of orderly deleveraging. However, in the event of mishaps, financial failure would be transmitted through the interconnected banking system quite quickly (Arvai, Driessen, and OtkerRobe 2009). The other risk is that these economies may experience stagnation in the medium run. That will have serious consequences for labor markets. Employment will decline anyway and slow growth will accentuate the already existing structural imbalances in these markets (high unemployment, significant segmentation, low employment), possibly leading to social problems and to growing populism. There is little that the EU can do to address that eventuality, short of engineering a strong recovery with strong import demand, which is not something that is being forecasted at the moment.

Conclusion in the CESE has been disrupted by the current crisis and it is not certain that it can be revived in the medium run. In addition, there are still significant risks that crisis may become even worse, especially if the process of deleveraging does not proceed in an orderly manner. Switching to the alternative growth model based on higher domestic savings would be difficult and would depend on the recovery of EU demand for exports from countries in transition. If that does not happen either, the return to convergence growth rates may prove problematic in the medium run. T H E N E O C L A S S I C A L M O D E L O F G R OW T H

Vladimir Gligorov is Senior Researcher at The Vienna Institute for International Economic Studies. References Arvai, Zsofia, Karl Driessen, Inci Otker-Robe (2009), “Regional Financial Interlinkages and Financial Contagion Within Europe,” IMF Working Paper WP709/6. European Commission (2009), “Impact of Current Economic and Financial Crisis on Potential Output,” European Economy, Occasional Papers 49 (June). Gligorov, V. et al. (2009), “Final Report on Financial Risks in Candidate and Potential Candidate Countries,” draft paper. Gligorov, V., J. Poeschl, S. Richter et al. (2009); “Where Have All the ‘Shooting Stars’ Gone?,” wiiw Forecast Report 4 (July).

SPECIAL REPORT

Small States Face Big Challenges BY K. DWIGHT VENNER Whether country size matters for economic prosperity depends on a country’s degree of economic integration with the rest of the world. —Alesina and Spolaore, The Size of Nations T H E C U R R E N T G L O B A L F I N A N C I A L and economic crisis is having an enormous impact on all of the members of the international community regardless of their size or stage of development. Nevertheless, the impact can differ considerably, both in reality and perception, depending on its scale relative to the overall size of the particular state, as well as the government’s financial capacity and ability to deploy a range of policy instruments. This article is organized as follows. First, it defines and identifies small states. Second, it sets out the economic fea-

tures that are associated with such states and that influence the impact of the crisis. Third, it presents as an example, the case of the Eastern Caribbean Currency Union (ECCU)1 and its response to the crisis. Finally, it puts forward a view on the role of the international community in assisting small states to prepare for and mitigate the impact of such crises.

What is a small state? S M A L L S TAT E S A R E 2 D E F I N E D

as those with populations of less than 1.5 million people. The World Bank has forty-eight such states in its current membership. These states are located in Africa (11), the Caribbean (12), Asia–Pacific (15), and other regions (10). They have varying geographic characteristics. Some are completely landlocked, while most are islands. Some are geographically distant from major regional centers

A taxi driver in Belmopan, Belize, waiting for customers.

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of development (Pacific) while others are closely connected; both conditions have their advantages and disadvantages. Some have valuable natural resources such as oil and diamonds, while others have little. Small states suffer from three major handicaps: Diseconomies of scale in production, marketing, distribution, and public administration; Exposure to high levels of risk because of small populations and limited physical space; and Limited scope and capacity for negotiating with larger states and private sector entities. ■

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Economic factors toward concentration of economic activities resulting in near monopolies or oligopolies. Exports are highly concentrated and imports highly diverse, giving them little room for price setting on either front. In short, they are price-takers. Small economies are highly open to external trade, linking them very closely with the fortunes of the international economy. The scope for their development therefore lies in two directions: deeper integration into the global economy, and concentration on those activities in which they have a relative comparative advantage that, with some effort, could be turned into a competitive advantage. Those countries that possess neither oil nor diamonds have gravitated toward two activities—tourism and finance. These sectors, however, are inextricably linked to the global economy, and have been greatly affected by the crisis. There has also been a dramatic decline in foreign direct investment in the tourism sector which, in turn, affects activity in the construction sector—a major contributor to employment. Small states also have large segments of their population living abroad who contribute to workers’ remittances which have also been affected by the current crisis. Empirical studies have indicated high levels of income and output volatility in small economies due to external shocks. Also noted are the lack of technical skills and institutional arrangements to manage such shocks. The food and energy crisis which immediately preceded the current crisis had an adverse impact on small states and lowered their capacity to deal with the current crisis. The fact is that the current crisis is just the latest and most intense of a number of such events dating back to the demise of the Bretton Woods arrangements in 1971. The period since then can aptly be described as the Age of Volatility. These financial crises seem to have become more virulent with the passage of time, and have occurred with increasing frequency. The Asian crisis, which had a worldwide effect, put pressure on the other area to which small economies had gravitated, that is, offshore finance. In an effort to design a new financial architecture a whole raft of standards and codes was developed, and a particularly stringent approach was taken to curtailing the activities of offshore financial centers. The same situation is occurring again as the OECD is now focusing its efforts on the offshore sector. This sector is thereS M A L L S I Z E T E N D S TO L E A D

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fore losing business because of the melt-down of the financial sector in the United States and Europe and the prospect of more restrictions in the future. The situation with the offshore financial sector raises some interesting and important issues for the international community, particularly the OECD, in the post crisis era. At present, it would appear that these services are supplied at competitive prices by many offshore centers located in small economies that have few alternative economic activities. If we assume that there are appropriate and effective measures to combat money laundering, tax evasion, and terrorist financing in all countries and that the demand for such offshore services is still extremely large—a distinct possibility given the fact that the movement and trading of financial instruments and services across borders far exceeds that of goods—then this activity constitutes a world market which should be accessible to all countries once the necessary regulatory safeguards are in place.

How did ECCU respond? (ECCU)3, with a population of approximately 600,000, has been severely affected by the crisis directly and by the collateral impact caused by the collapse of a regional insurance conglomerate because of imprudent investments in the U.S. and the fallout from the Securities and Exchange Commission (SEC) charges against the Stanford Group of Companies. The scale of the direct impact of the crisis on the ECCU economies can be seen from the decrease in inflows of tourism receipts and foreign direct investment which have accounted for, on average, 28 percent and 23 percent respectively of GDP in the last three years. Travel receipts fell by 2.5 percent ($80.3 million) in 2008, in contrast to a 3 percent increase in 2007; while foreign direct investment inflows contracted by 29 percent ($1 billion) in contrast to an increase of 14.6 percent in 2007. This has had a negative effect on the central governments’ finances and debt. In particular in 2008 the central governments realized a current account surplus of $77.5 million (0.6 percent of GDP) substantially below that of $303.2 million (2.5 percent of GDP) in the previous year; while their total outstanding debt rose by 2.4 percent to $9.3 billion (73.2 percent of GDP). The ECCU countries, which are united by an integration arrangement through the Treaty of Basseterre (1981) and by a common currency and central bank through the Eastern Caribbean Central Bank (ECCB) Agreement (1983), have responded at both the country and currency-union levels by invoking the provisions embedded in the articles of both treaties. The Organization of Eastern Caribbean States (OECS) Authority and the ECCB Monetary Council, the highest decision-making bodies of both arrangements, have intervened in both the banking and insurance sectors to take over and restructure ailing institutions. They have also accelerated the process of implementing a comprehensive regulatory and supervisory regime to meet the current and future challenges. THE EASTERN CARIBBEAN CURRENCY UNION

APPENDIX I: COMPARATIVE INDICATORS FOR SELECTED SMALL STATES—2007

LATIN AMERICA

COUNTRY Antigua & Barbuda Bahamas, The Barbados Belize Dominica Grenada Guyana St Kitts & Nevis Saint Lucia St Vincent & the Gren. Suriname Trinidad & Tobago

27 30 32 29 42 44 41 40 16 10 39

441 558 632 457 1,230 1,303 1,199 1,186 148 81 1,045

POPULATION (thousands)

COUNTRY

POPULATION (1=smallest)

POPULATION (1=smallest) 8 23 21 20 9 12 35 6 17 14 26 43

68 303 267 240 73 98 761 41 156 115 417 1,301

EAST ASIA PACIFIC

Cape Verde Comoros Djibouti Equatorial Guinea Gabon Gambia, The Guinea-Bissau Mauritius Sao Tome & Prin. Seychelles Swaziland

POPULATION (thousands)

Brunei Cook Islands Fiji Kiribati Marshall Islands Micronesia, Fed. Sts. Nauru Niue Palau Samoa Solomon Islands Timor—Leste Tonga Tuvalu Vanuatu COUNTRY

OTHER REGIONS

AFRICA

COUNTRY

POPULATION (1=smallest) 24 5 38 11 7 15 3 1 4 18 28 36 13 2 19

338 20 812 96 52 118 11 2 19 170 447 800 100 11 197 POPULATION (thousands)

POPULATION (1=smallest) 33 37 34 45 22 25 31

691 805 757 1,369 276 390 585

Bahrain Bhutan Cyprus Estonia Maldives Malta Qatar

Source: ECCB

APPENDIX II: ECCU SELECTED DATA - 2008 REGION

Anguilla Antigua And Barbuda Dominica Grenada Montserrat St Kitts And Nevis Saint Lucia St Vincent and the Grenadines ECCU

POPULATION (thousands)

NOMINAL GDP (ECSM)

TOURISM RECEIPTS (ECSM)

FOREIGN DIRECT INVESTMENT (ECSM)

15 68 73 98 5 41 156 115 571

784.21 3,299.81 1,011.14 1,831.92 135.65 1,513.42 2,665.31 1,571.06 12,812.52

273.79 902.42 217.95 283.32 19.02 328.09 839.69 243.98 3108.26

240.65 684.08 140.69 435.26 5.15 236.68 282.82 326.64 2,351.97

Source: ECCB

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The ECCU authorities have also developed an Eight Point Stabilisation and Growth Programme to address the immediate global crisis which focuses on: Financial Programs Fiscal Reform Debt Management Public Sector Investment Social Safety Net Financial Sector Safety Net Amalgamation of Local Banks Rationalisation of the Insurance Sector ■ ■ ■ ■ ■ ■ ■ ■

The role of the international community A R E O N G O I N G with the International Monetary Fund (IMF) following Article IV consultations with individual countries, and the IMF Annual Currency Union Review to identify the types of programs that would be appropriate in the current circumstances and to work out access to Fund resources under the new arrangements following the G20 meetings. Most of the countries have already approached the Fund under the Exogenous Shock Facility (ESF). The financial programs which each country has already formulated would be the platform on which the Fiscal Reform and Debt Management Programs will be established. The fiscal reform program had started prior to the crisis with recommendations by a Tax Reform and Administration Commission which resulted in the implementation of value added taxes, property taxes, and adjustments to personal and business taxes. The current goal would be expenditure reform and rationalisation of government expenditures to increase the value added for critical sectors. The Caribbean Development Bank, with its Policy Based Loans and the World Bank with its Development Policy Loans are critical partners in the Fiscal Reform Program. Debt management is being given high priority as most countries have extremely high debt to GDP ratios, which have severely limited the fiscal space to respond to the crisis. The Canadian government, the IMF, and the World Bank are supporting the ECCU member countries in taking a structured approach to effective debt management. DISCUSSIONS

These first three programs, vigorously executed, are the prerequisites for approaching the international community to fund and provide technical assistance for the next three. Public sector investment programs, in the absence of domestic fiscal space, would constitute the fiscal stimulus required to generate economic activity through quickly activated and disbursing projects. Social safety net programs through transfers and retraining are considered important to protect the vulnerable and unemployed. Financial safety net programs require financing to restructure and recapitalize stressed institutions, and technical assistance to facilitate the development of robust regulatory and supervisory regimes. If these three are not adequately supported by external sources then the difficulty of successfully executing the first three will increase significantly. The amalgamation of local banks is critical to the creation of a strong banking sector that is adequately capitalized and has the capacity to survive in difficult situations. The sector is now overbanked with increased exposure of smaller and weaker banks and high overhead and unit costs. The insurance sector is similarly overpopulated with agency arrangements that have left the sector highly fragmented and under-regulated. These initiatives, emanating from the currency union arrangements and supported by external assistance, should help alleviate the impact of the crisis on these countries.

Conclusions that can be derived from the experience of small states in general, and those of the ECCU in particular, are as follows: Financial stability, given its beneficial global effects, should be considered an international public good. Efforts should be redoubled to ensure that meaningful reforms take place. The international community, through the IMF and the World Bank, should develop financial and social safety nets in consultation with the small states to address their particular problems. Small states should use the crisis to experiment with fundamental and creative fiscal and monetary policies to mitigate the impact of exogenous shocks. Given the extreme vulnerability of small states, these measures can contribute significantly to their survival and advancement in an increasingly volatile environment. THE CONCLUSIONS

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K. Dwight Venner is Governor of the Eastern Caribbean Central Bank. Endnotes 1 The ECCU is comprised of the eight countries, which are members of the Eastern Caribbean Central Bank, namely, Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St. Kitts and Nevis, Saint Lucia and St. Vincent and the Grenadines.

The boardwalk of Belize City, the nation's principal port and its financial and industrial hub.

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2 See Table 1 3 See Table 2

SPECIAL REPORT

Policy Responses to the Global Economic Crisis BY JUSTIN YIFU LIN T H O U G H M A N Y K N E W that the risks of a severe financial crisis were mounting, the necessary changes in policies and practices, both in mature economiesâ€™ financial sectors as well as in many new emerging markets, were stymied by procrastination during the 2003â€“2007 boom.1 No one was willing or capable of taking the punch bowl from the party2 and the global institutional set-up did not have the leverage to do so. Most

economic and financial experts severely misjudged the timing, and underestimated the speed and severity of the current financial crisis. As a result, despite strong macro policy responses, the current situation (in July 2009) remains full of uncertainties. Going forward, the key challenges will be to accelerate the recovery with adequate macroeconomic policies, to increase future productivity in developing countries, while, at the same time, enhancing the regulatory framework of the financial sector to prevent new crises and avoid asset bubbles.

More than 200 enterprise managers signed a billboard that promises: "No job cuts. No salary cuts. Tide over difficulties," in Hangzhou City, China.

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The global economic crisis of the origins of the global financial crisis: lax macroeconomic policies, in a context of weak prudential and regulatory oversight, led to excessive leverage, mispricing of risk, and the build-up of global systemic risk. The global financial crisis exposed a number of previously known, documented, but unresolved fragilities within the increasingly integrated financial system. The crisis also revealed that surveillance of macroeconomic and financial sector policies must be even-handed for all countries, developed and emerging markets alike. While emerging markets, having learned lessons from the crises of the 1990s, were closely monitored both by markets and international financial institutions (IFIs), their capacity to influence macro and regulatory policies in mature economies has proven to be limited. This has been particularly true in large economies issuing a global currency which experienced little incentive to adjust domestic imbalances since external financing needs were matched by the excess savings attracted by the depth and liquidity of U.S.-denominated asset markets. The global economy benefited from the strong 2003–2007 business cycle which was clearly unsustainable. The losses precipitated by the financial crisis have been enormous. Total capitalization of world stock markets was almost halved in 2008, representing a loss of nearly $30 trillion of wealth. So far in 2009, markets have recovered about $2 trillion. In the United States alone, the wealth loss for households related to the fall in home prices was roughly $4 trillion by the end of 2008. Losses of this magnitude have significant wealth effects on consumption and savings. Indeed, the current global crisis is not limited to the financial sector and is now affecting real economic sectors. Industrial production in the first quarter of 2009 fell 23 percent in Eastern Europe, 62 percent in Japan, and 42 percent in Germany, at seasonally adjusted, annualized rates (SAAR). Globally, industrial production declined by 28 percent in the first quarter following a 22 percent fall in the final quarter of 2008, before easing to a pace of contraction of 19 percent in April (on a rolling quarterly, SAAR basis). During the first quarter of 2009, for East Asian economies, such as China and Japan, exports declined by 50 percent or more, and 43 percent in Korea. This year we will encounter the largest trade contraction since 1929. Commentators, papers, and reports3 have compared the nature and intensity of the present global recession with past episodes such as the Great Depression of the 1930s and the Japanese Recession of the 1990s: W E N OW H AV E A R E A S O N A B L E U N D E R S TA N D I N G

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Like the Great Depression, the current crisis originated from the U.S. financial system. The size and interconnectivity of the U.S. economy facilitated the contagion of the crisis, following the bankruptcy of Lehman Brothers.4 Unlike the bank runs of the 1930s, this financial crisis involved complex financial instruments, harder to re-price, and globally disseminated in the balance sheets of a variety of financial institutions. This created new channels for rapid transmission. The boom was bound to turn to bust. And in

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mid-2007 this process began with the crisis unfolding in the subprime mortgage market in the U.S. The drop in the value of the off-balance sheet assets pushed many financial institutions into insolvency. Even worse, the financial innovations of the past decade—many of which had been sold on the promise that they would diversify and minimize risk—turned out to be the transmission mechanism for instability. The (relatively small) subprime mortgage crisis thus became a full-fledged global financial crisis. The pre-crisis global build-up of capacity in the real economy, specifically in the housing and manufacturing sectors, will result in excess capacity even after the global economy starts recovering. As households respond to the sudden loss of wealth, by reducing consumption, and the deleveraging of the financial sector reduces the funds available for investment, aggregate demand will decline. The capacity utilization rate of the manufacturing sector was 69.1 percent in the U.S. in March, 2009, the lowest since statistics began to be collected in 1967. In Germany it was 72 percent and in Japan 65 percent—all record lows for recent decades. Once excess capacity appears, the economy gets trapped in a vicious cycle, it becomes hard for firms to find viable investment opportunities, investment demand declines, and some firms are forced into bankruptcy. This, in turn, threatens the income and job security of workers, who then try to reduce spending, and so on. Finally, small, open developing economies typically use currency depreciation and the resulting export-driven growth to come out of a crisis. However, this is impossible in a globally depressed environment. Policy instruments in both developed and developing countries are likely to be less effective without coordination. And unless we deal with the excess capacity, we will all experience a protracted crisis.

Beginning in mid-March 2009 amid signs of a recovery in the United States, and confidence that no further major financial sector collapses were in the works, markets began to strengthen and capital flows to developing countries picked up. Equity flows to developing countries in the first two months of the second quarter exceeded the total for the first quarter, while bank lending and bond issuance both accelerated. Partly as a result, returns on emerging market assets surged. Since mid-March developing country markets are up 33 percent as compared with only 19 percent for high-income countries. Nevertheless, markets remain well below pre-crisis highs. Equity markets, often considered an early indicator of recovery, are pointing firmly to a pick-up, especially in the United States5 and in a number of developing East Asian economies. These developments are consistent with a turning point in the crisis. The prognosis for Europe and Japan, however, is less upbeat. Although surveys show that consumer and business confidence are improving, economic statistics continue to deteriorate. Much uncertainty remains. Global output is now expected to shrink by 2.9 percent in 2009, the first contraction since World War II; world trade is likely to contract by 10 percent in 2009; and unemployment will soar in industrial countries, as

high-income countries reel from an unprecedented assetmarket bust.

The policy responses rapid and comprehensive monetary6 authority interventions helped to avert a global financial collapse at the end of 2008. The broad nature7 and size of interventions—in most cases expanding the public sector balance sheet, has been unprecedented in modern times. The size of interventions in the financial sectors during 2008–2009 was large, totaling on average for advanced economies about 50 percent of their purchasing power parity (PPP) weighted GDPs. Yet despite capital injections, special liquidity facilities, monetary easing, provision of guarantees, stress-testing, and the announcement of financial restructuring plans, the status of financial sector balance sheet repair is still uncertain. In addition to support to the financial sector, the global economy is facing an unprecedented problem of coordination. Addressing the crisis requires a broad, decisive, and globally coordinated policy action in the form of a fiscal stimulus that goes beyond national boundaries. In most cases, G20 countries have adopted—in addition to support of their financial sectors—fiscal stimulus measures that reached 0.5 percent of their average GDP in 2008, 2 percent in 2009 and 1.5 percent in 2010. A particular emphasis was placed on discretionary spending on infrastructure, given its higher multiplier effects. Conversely, there is much more certainty about the damage done to the development efforts and prospects of developing countries, where the room for policy maneuvers is smaller. The GDP growth rate in developing countries in 2009 is forecast to drop to 1.2 percent, a sharp decline from 8.1 percent in 2007 and 5.9 percent in 2008. This decline alone will cause more than 30 million workers to lose their jobs according to the United Nations International Labor Organization and, of course, poverty will rise. In fact, if we do nothing, this situation could turn into the worst case scenario. With the crisis taking its toll, it is estimated that total foreign direct investment (FDI) and private capital flows will decline from $1.2 trillion in 2007 to $363 billion this year. As a result of declining exports and reduced capital inflows, developing countries may encounter a financing gap of between $352 billion and $635 billion. Moreover, remittances are likely to fall by 7.3 percent in 2009 to a level of $305 billion. Estimates for 2009 suggest that lower economic growth rates would trap 53 million more people in poverty—those living on less than $1.25 a day—than was expected prior to the crisis. If the $2 a day poverty line is used, 65 million will stay trapped. If the recession is protracted, more and more people will fail to get out of poverty. Contrary to the predominant view during 2003–2007, when some saw a “decoupling” of business cycles between industrialized and emerging economies, the post-Lehman, end-2008 acute turmoil still produced contagion effects from developed to all developing countries. The short-term consequences of the global financial crisis have been extensive, I N C O N T R A S T TO T H E G R E AT D E P R E S S I O N ,

including: the sudden halting of financial flows (from markets); the limited room for additional concessional aid by donors; the fall in remittances due to rising unemployment of unskilled workers; global trade contraction; increased need for budgetary resources to contain the dramatic poverty impact of this global crisis; the ensuing credit crunches (including trade-financing); the abrupt fall in commodity prices for many exporters; the consequent exchange rate volatility due, inter alia, to portfolio composition shifts; massive deleveraging; and abrupt profit repatriation. The longer-term implications of the global financial crisis for developing countries are more difficult to discern. The relative stability of developing country yields since the beginning of the year suggests that the borrowing costs for these countries may not rise by as much as feared. That said, capital flows are much lower than in the past, and are not expected to return to pre-crisis levels anytime soon. As a result, financing of both private and government sector investment is likely to be more difficult for some time, with implications for longerterm potential output. Developing countries have been affected in varying degrees by the transmission of the global financial crisis depending on their level of integration in global financial markets and their specific external dependency, for example, on external financing by capital markets, on exports, on aid, on expatriate labor income, and so forth. It is noteworthy that several developing countries are navigating this crisis better than previous episodes. Having translated the lessons of previous crises into robust policy frameworks and stronger fundamentals, they are now capable of implementing countercyclical policies, whereas in the past (for example, during the Mexican, East Asian, and Russian crises), the need for immediate stabilization led inevitably to contractionary policy frameworks to rebuild confidence and credibility.

Policy challenges ahead about exit options, for the time being the primary policy challenges concern the need for interventions to sustain global demand and policy coordination. On the one hand, developed countries are focused on repairing their financial sectors, stimulating the real economy, and trying their best to coordinate fiscal and monetary policy initiatives. Many are using the expansion of their public sector balance sheets, but also need to pay attention to their credit ratings and medium- and long-term loan (MLT) debt sustainability. On the other hand, we have: (a) middle-income countries that have both excess capacity in the production and export of manufactured consumer goods (to high-income countries) as well as with the need to import capital goods; and (b) low-income countries that have excess capacity in the production of commodities. In both middleincome countries and low-income countries, there is evidence that investment in infrastructure has lagged due to a number of chronic problems such as past and present fiscal constraints, quality of governance, technical capacity to idenDESPITE SOME PRELIMINARY DISCUSSIONS

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tify sound projects, political economy issues, and so forth. Hence, while there is uneven room for fiscal maneuvering in developing countries, the crisis should, nevertheless, be an opportunity to identify targeted investment that would increase future productivity and position these countries to be more competitive in the aftermath of the crisis. Infrastructure seems a logical sector in which sound projects could produce high returns and multiplier effects. In 1998, because of the East Asian financial crisis, China encountered a situation very similar to the current one. The Chinese government adopted a fiscal stimulus package in 1998–2002 to remove bottlenecks in infrastructure. In 1997 China had only 4,700 kilometers of highway, by 2002 this had increased more than five times to 25,000 kilometers. The transportation capacity improved greatly as did port facilities and the electricity grid. With that kind of fiscal stimulus, China maintained its average annual growth rate at 7.8 percent. More importantly, after the crisis the growth rate accelerated. Between 1979 and 2002, the average annual growth rate in China was 9.6 percent. And between 2003 and 2008, the growth rate actually increased from 9.6 percent to 10.8 percent. This growth was made possible by investment targeted to freeing-up bottlenecks, that is, those sectors constraining growth in the economy. As a result, though government debt as a percentage of GDP initially rose from about 30 percent of GDP to 36 percent in 2002 it then declined as growth increased. By 2006-2007, government debt had fallen to 20 percent of GDP. The lesson to take from China’s experience is that, if the return is high enough to generate higher growth, sufficient revenues can be generated to pay for the costs of the fiscal stimulus itself. That is, the project may be “self sustainable.” Whereas opportunities for growth-promoting fiscal stimuli may be

Applicants attend a job fair in the Makati financial district of Manila, Philippines.

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mostly exhausted in developed economies, in developing countries, by contrast, opportunities for investments that help break through bottlenecks to growth tend to abound. Although some fraction of fiscal resources must be injected in developed countries that are at the epicenter of the current crisis, the main policy objective should be to create demand as quickly and efficiently as possible. This can be done by channeling investment to where it can be most effectively utilized: by investing in eliminating bottlenecks to growth in the developing world. Lack of infrastructure in many developing countries, both domestic and regional, is the main bottleneck to growth. Increasing investments in infrastructure can raise the productivity of the private sector, improve the business environment, and generate high economic returns. This must be supported with increased financing and underpinned by improvements in the efficiency and effectiveness of public spending. Policy makers also need to prevent future crises in the financial sector. We know that this global financial crisis was caused in part by failures of the pre-crisis regulatory and supervision framework, especially in the G7. After the crisis, many reports and proposals8 are calling for a strengthening of prudential regulation, a more accurate evaluation of risk, and a tightening of accounting standards. The pre-crisis regulatory framework allowed distortions in banks’ behavior and the financial intermediation process and did not control financial pro-cyclicality. There were strong incentives to bypass required capital regulations by shifting loans off banks’ balance sheets. Furthermore, the risk models did not take into account “extreme events” and mispriced risk, and there was lax governance in the financial sector industry, including in its internal, short-term based compensation rules. Looking ahead, some of the areas for reform include: changes in compensation schemes in the financial industry with more emphasis on evaluating long-term performance and results; better supervision of excessive leverage and asset quality; comprehensive registration of all financial transactions, including over-the-counter (OTC) operations (especially for highly leveraged agents and derivative markets); reassessment of the role and oversight of rating agencies; and better capital requirements rules (Basel II) that can smooth business cycle fluctuations by reducing pro-cyclicality. The current crisis is the first “synchronized” crisis in almost eight decades and as a result, dealing with it is beyond the capability of any single country. Instead, decisive and concerted actions are needed by the international community as a whole. In particular, there is a need for a global, coordinated fiscal stimulus. For example, in the spirit of building our common global future, developed

countries need to consider, in addition to their domestic efforts, using part of their resources to make investments in developing countries. This will not only help the latter, but also the former. It would support short-term recovery, but also help lay the foundation for a sustainable, inclusive growth in the longer run.

excess liquidity which, in turn, contributed to the large increases in real estate and equity investments in the United States, as well as private capital flows to the developing countries, supporting their investments in the manufacturing sector. These events and actions, together with financial innovations induced by financial deregulation, created a boom in the housing market, which later became an equity bubble. As markets surged, the perceived wealth effects prompted households to divert a steadily increasing share of their income to consumption.

Conclusion

2 Perhaps the gradual tightening by the U.S. Federal Reserve beginning June 2004 represented the first calculated bet to try to smooth the cycle.

(as of July 2009) some “green shoots” pointing to a bottoming-out of the crisis, it is too soon to speak of a recovery that includes stabilization of mature economies and resumption of strong growth in developing countries. We can, however, identify some key forces that are likely to shape any future recovery and growth path. The post-crisis global growth pattern may be slower than in the pre-crisis period, in part because of the need to rebalance growth in the global economy and reduce excessive current account imbalances. This correction will take many forms (and some time), including changes in private consumption in the U.S. and surplus countries, movements of relative prices (for example, energy, minerals, food, and so forth), and better control of the financial industry through lower leverage ratios and simpler financial products, all potentially contributing to a lower trend growth for the next cycle. Also, at some point, current stimulus policies (both monetary and fiscal) will need to be unwound. That will reduce the momentum of global growth to some extent and will have to be carefully timed to avoid both the dangers of inflationary pressure and a premature shock to aggregate demand. A rise in protectionist pressures would take a toll on trade and growth. Finally, investment may be dampened for some time by the need to absorb the high excess capacity that currently exists in the world economy. The implications are clear for developing countries: those who will have tailored their fiscal stimulus well, removed bottlenecks to growth, and invested adequately in human and physical capital within the limits of their fiscal room for maneuver, will be naturally better-off and ready to begin a new and more robust growth cycle based on their comparative advantages in the global economy. For the IFIs, helping this process unfold through lending and technical assistance while also building global public goods will be a challenging agenda for the next few years. W H I L E W E A R E O B S E RV I N G

Justin Yifu Lin is Senior Vice President and Chief Economist of the World Bank. Endnotes 1 Although there were differences of viewpoints (Bernanke’s savings glut and preference for U.S. assets) numerous warnings were expressed by many academics (Obstfelt, Rogoff, Krugman, Roubini, and others.) and IFIs on global imbalances and their possible abrupt unwinding with consequences for exchange rate and asset price stability. The current crisis was preceded by six years of boom in the global economy which can be traced to the bursting of the Internet bubble in 2001, and the subsequent expansionary monetary policy pursued by the United States Federal Reserve Board. This led to

3 Among many sources, M. Wolf “The recession tracks the Great Depression”, FT, June 16th, 2009 quoting B. Eichengreen and O’Rourke “A Tale of Two Depressions”, June 2009, www.voxeu.org; The World Economic Outlook (WEO), Spring 2009, especially Box 3.1 pg. 99, IMF; the OECD Economic Outlook, Volume 2009/1, No.85, June; the World Bank’s Global Development Finance (GDF) 2009, June 2009, etc. 4 The eruption of the financial crisis after Lehman’s bankruptcy in September 2008 included a widespread surge in pre-cautionary saving and flight to quality. As a result, virtually every currency in the world fell with respect to the dollar, and the yield on U.S. government bonds dropped by more than 200 basis points. Simultaneously, spreads on risky assets, including developing country sovereign and corporate bonds, surged by as much as 800 basis points. In the months immediately following the crisis, global financial markets remained volatile and uncertain, the Chicago Board of Trade’s VIX index almost quadrupled from a level of 20 in early September to 8 in November. Global equity markets effectively collapsed (with the Dow Jones Industrial Average down some 30 percent by mid-November). Equity markets in developing countries were hit especially hard in this market fallout, with the Morgan Stanley Capital International Emerging Market (MSCIEM) index falling 42 percent over September 2008 to a trough in early March 2009. 5 In this overall context it is difficult to evaluate with precision recent movements in the yield on U.S. Treasuries. Their recovery to levels observed prior to the crisis is consistent with a return to normality and the partial reversal of the capital outflows from developing countries that characterized the most acute phase of the crisis. This interpretation is consistent with the recent tendency for the dollar to depreciate against other currencies and for the spreads on developing country bonds to fall. Indeed, as compared with the movement in spreads, yields on developing country bonds have been relatively stable. 6 See IMF Staff Position Note, “Fiscal Implications of the Global Economic and Financial Crisis,” SPN/09/13, June 9, 2009 7 There was, so to speak, no “countercyclical policy response” in the 1930s with countries locked into “gold standard” regimes and balanced budget fiscal frameworks. Monetary policy was only gradually eased by 1932-33 and financial repair/restructuring started later after some 2-3 years into the crisis. By contrast, by the end of 2008, in the current crisis, policy-makers have used almost every conceivable policy tool and more: capital injection, direct purchase of troubled assets and discretionary lending by treasury, central bank support with treasury backing, liquidity provision and various other special facilities by central banks, Guarantees, upfront government financing, even sometimes outright nationalization and liquidation of financial institutions, and so forth. 8 Financial Services Authority-FSA, “The Turner Review, A regulatory response to the global banking crisis,” (March 2009); Global Financial Stability Report-GFSR, International Capital Markets Department, IMF (2009); The High Level Group on Financial Supervision in the EU, report, Chairman Jacques de Larosière, EU, Brussels, February 25th, 2009; International Monetary Fund, “Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management,” Monetary and Capital Markets Department, IMF, February 4, 2009; International Center for Monetary and Banking Studies, “The Fundamental Principles of Financial Regulation,” Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash Persaud and Hyun Shin, preliminary conference draft, January 2009.

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SPECIAL REPORT

Coming Out of Recession The role of business in alleviating poverty BY V. KASTURI RANGAN AND DJORDJIJA PETKOSKI

The post-crisis business climate is affecting developing countries in two major ways: sharp reduction in capital inflows and the collapse in global and local demand. Global output is expected to shrink by 2.9 percent in 2009: while the GDP growth in developing countries is projected to decline from 5.9 percent in 2008 to 1.2 percent in 2009 it will still outperform those of developed countries whose aggregated GDP is projected to fall 4.5 percent.1 Lack of demand and limited THE CURRENT FINANCIAL CRISIS

access to capital are causing a sharp contraction in the production and global trade of manufactured goods. Global industrial production declined by 20 percent in the fourth quarter of 2008, as high-income and developing countriesâ€™ activity plunged by 23 and 15 percent, respectively.2 Weak global demand is compounded by a decrease in trade finance as well as increased costs. International trade is likely to experience its largest decline in 80 years. Unemployment is rising with unprecedented job losses, in some countries poised to hit double-digit rates. Furthermore, employment is increasingly moving out of dynamic export-oriented sectors into lower-productivity activities.

People in La Paz, on the outskirts of Mexico City, were able to buy construction materials for their houses in Chicago through CEMEX (Cementos Mexicanos) programs.

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Foreign capital inflows—remittances, international syndicated bank lending, private capital investments, and bond issues—collapsed in the aftermath of the crisis. Global financial markets remain uncertain and unstable, and prospects for capital flows to developing countries are dim. Global investors retreating from developing countries resulted in a decline of total private capital flows in 2008 to $707 billion with an expected further decline in 2009 to $363 billion.3 MSCI Emerging Market Index sank 55 percent in 2008, erasing about $17 trillion in market valuation. Net private debt and equity flows to developing countries are projected to decline to 2 percent of GDP in 2009, compared to 8.6 percent of GDP in 2007. At the same time, much of the external debt of approximately $1.2 trillion, raised by developing country banks and firms between 2003 and 2007, is now maturing. The cost of external borrowing has increased to 11.7 percent, compared to 6.4 percent in the pre-crisis years.4

Business response but companies as well were surprised by the speed and scope of the downturn. As demand for goods and services collapsed, and uncertainty about future demand is increased, companies have found it difficult to make any serious commitment to new investment. Governments can mitigate the impact of the crisis by helping to stabilize the financial sector, preserving jobs, and protecting people. The focus should be on restoring confidence in the financial system and supporting increases in aggregate demand. By reducing the risk of doing business, governments can stimulate the private sector to mobilize the substantial financial resources waiting to be invested. Small and medium enterprises (SMEs) are especially affected by limited access to finance. It is critical for governments to help entrepreneurs emerge from the crisis by facilitating access to finance for SMEs and microfinance institutions, and to support the recovery process through policies that promote growth and employment generation. A recent study by the Kauffman Foundation indicates that many leading companies today were formed in uncertain times. For example, more than half of the companies on the 2009 Fortune 500 took shape during a recession or bear market. Although individual circumstances vary, companies generally have a broad range of options for responding to the crisis. One of the most urgent needs is to ensure rapid debt workouts. The financial crisis contributed to a sharp increase in corporate bankruptcies and “fire sale” of assets. The challenge for many developing countries is that institutional constraints, such as weak judicial systems, make bankruptcy procedures inefficient and time consuming.5 The way in which corporations respond to this challenge—their ability to roll over their maturing debt—will have a big impact on the developing countries’ ability to meet their external financial needs. Companies account for some 75 percent of the medium- and long-term private debt coming due in 2009. N OT O N LY G OV E R N M E N T S

The role of business in poverty alleviation and significant poverty reduction, weaker growth in many developing countries will lead to an increase of some 46 million people living in poverty in 2009 .7 The world is facing another crisis—a poverty crisis that is going nearly unnoticed in the midst of the financial crisis. While putting their “business house in order,” corporations will likely face another dilemma—how much, if at all, can they help meet the needs of the poor, especially in developing economies. Our view is that the financial crisis is an opportunity. AFTER A DECADE OF STRONG GROWTH

Some strategies A S S A L E S , P R O F I TA B I L I T Y, and investor confidence continue to deteriorate, for many companies the most urgent need is to reduce costs. According to a recent Ernst & Young survey, cash remains a major concern for 82 percent of businesses worldwide. Almost 9 out of 10 companies are looking for cost reductions, and 4 out of 10 companies accelerated significant employee reduction.8 Companies looking for ways of preserving cash and pursuing growth should reassess their tax positions, since taxes are normally their 3rd to 5th biggest expense. Many government stimulus packages have included significant tax measures as a response to the crisis. According to a recent OECD report, tax measures represent 56 percent of the net effect of fiscal stimulus on average among OECD countries. However, the issue of how favorable tax policy can support business development is complicated by the increasing government deficits and revenue needs. Global GDP is forecasted to increase a modest 2.0 percent in 2010 and 3.2 percent in 2011. This will result in a very slow job recovery, and recession-like conditions will continue to prevail. Companies are employing various strategies to deal with employment issues. Some companies utilize their corporate social responsibility programs to create new jobs or preserve existing ones through temporary salary cuts and introducing shorter working hours. Some companies use more than one business model to achieve both profitability and jobcreation objectives. For example, the Grameen group has generated significant profits through its GrameenPhone group which employs only about 600, while at the same time creating more than 100,000 through the GrameenTelecom group which yields lower profits. The growth rates in emerging markets will continue to be higher than in OECD countries and more emerging-market multinationals are building very strong positions in their industries. Hyper competition will speed the declining growth and fast commoditization of high-income market segments, thus putting an additional pressure on companies to expand their markets in developing countries. Furthermore, pressure on companies to create jobs and do business with low-income groups will increase. The traditional corporate response to financial crises based on cost-cutting, restructuring and

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layoffs, aimed at preserving cash and increasing efficiency and productivity, should not be pursued alone and at the expense of more innovative solutions. In a recent McKinsey & Company survey more than 50 percent of the respondents said that innovation is more important to growth now than it was before the crisis.9 Long-term global prosperity and stability need to be supported by expanding growth, especially among the low-income segments. For example, because severe competition with local companies in India resulted in reduced profit margins at the highincome market segment, Unilever felt pressure to cultivate low-income groups. The company has had outstanding success in these markets, offering products in single-use packaging (for example, sachets of shampoo and mini-size soaps), that were affordable to consumers. By extending its distribution networks to rural towns through travelling sales agents (on bicycles and even bullock-carts), the company has continuously increased its market share in countries like India, Indonesia, and Brazil. The multinational cement producer CEMEX learned a similar lesson during the last financial crisis in Latin America. For CEMEX the crisis was an opportunity to reengage with low-income market segments, and profitably provide housing to the poor, while also creating jobs. CEMEX chose to put an interdisciplinary team of its own employees on the ground in Mexico to better understand the social and home-building practices of low-income communities, using that knowledge to develop a successful product line of affordable housing just for the poor. This approach has also been used in several other Latin America countries and in Egypt. Growth based on tapping into low-income markets should aim primarily at wealth creation, including providing access to jobs, healthcare, education, and vocational training. This objective should even precede the marketing of consumable goods and services that help improve the quality of life of the poor. Arguably, businesses that have provided jobs and income to low-income people have been the most successful. They have given people the ability to buy healthcare and education for their children, and acquire property to improve their quality of life. They normally base their business models on a holistic assessment of how their labor policies and supply chain relationships can shape their strategy. Nestlé’s Milk District Model illustrates this approach. By providing opportunities for training, education, and a steady income to poor rural farmers in exchange for a consistent milk supply, Nestle effectively integrated poverty alleviation into a business model that was mutually beneficial: the company has been able to increase its supply of fresh milk and poor communities have benefited from job security, improved nutrition, and a better standard of living. Similarly, Bimbo in Mexico offers its 30,000 travelling salespeople the opportunity for continuing education, supplementary health care in addition to the government-supplied plan, and even a cooperative to help them acquire housing material to upgrade their living environment. The company has also attempted to bring microfinance to its 100,000 small retailers, and acted as an agent for health and property insurance. Admittedly all this has been done in

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order to ensure the success of its main line of business: making and selling bread and other edible foods and snacks. Because of the financial crisis, access to basic services, as well as their quality has deteriorated. Education is one example, since school attendance tends to decline in low-income countries as incomes drop. The potential for partnering with business in addressing these issues has not been fully tapped. Business can play an important role in reducing the number of school dropouts by implementing innovative programs. For example, Tetra Pack has a program in Nigeria that provides school meals as part of its philanthropic corporate social responsibility strategy; while Britannia has a similar program in India which, was initially supported in part by the Global Alliance for Improved Nutrition (GAIN),10 but which is now primarily profit based. The financial crisis creates unique opportunities for government and companies to reassess their strategies and identify innovative solutions, including creative partnerships, to tackle the new economic reality the world is facing. Those who react quickly and forcefully will most likely be the rule makers and winners in the post-crisis world. V. Kasturi Rangan is Malcom P. McNair Professor of Marketing and Co-Chairman, Social Enterprise Initiative, Harvard Business School. Djordjija Petkoski is Lead Specialist, World Bank Institute Endnotes 1 “Global Development Finance: Charting a Global Recovery.” The World Bank. 2009 2 “Swimming Against the Tide: How Developing Countries are Coping with the Global Crisis.” The World Bank. 2009 3 “Global Development Finance: Charting a Global Recovery.” The World Bank. 2009 4 “Global Development Finance: Charting a Global Recovery.” The World Bank. 2009 5 Atish R. Gosh, Marcos Chamon, Christopher Crowe, Jun I. Kim, and Jonathan D. Ostry. “Coping with the Crisis: Policy Options for Emerging Market Countries.” International Monetary Fund. 2009 6 “Global Development Finance: Charting a Global Recovery.” The World Bank. 2009 7 “Swimming Against the Tide: How Developing Countries are Coping with the Global Crisis.” The World Bank. 2009 8 “Opportunities in Adversity.” Ernst & Young. 2009. Ernst & Young interviewed a large number of managers and owners of companies around the world, first in January 2009 and again in June 2009. The main findings include: about 82 % of respondents still having difficulty in accessing credit and this is impacting upon their investment strategy; companies are facing heightened concerns over risks while managing their assets, and over the likelihood of more regulations; companies are using this crisis to outsource (23%) and use strategic acquisitions (34%); about 32% are disposing off assets to increase cash and liquidity; in January 2009, only 20% planned for entering new geographic markets but by June 2009, 33% expect to. 9 “The crisis—one year on: McKinsey Global Economic Conditions Survey results,” September 2009. 10 GAIN has formed a Business Alliance to explore the space between philanthropy and strategic private sector interest by developing new business models to fortify foods with necessary vitamins and minerals and making it available and affordable to the poor.

SPECIAL REPORT

Trade Openness Is Now More Important Than Ever BY ANNE O. KRUEGER

Successes of trade liberalization it is easy to forget that the international economy has experienced unprecedented growth over the past sixty years. Despite the present downturn, living standards in almost every country are higher than they have ever been; life expectancy is at an all time high, the growth rate of world real GDP has been higher on average than in any period in economic history, and some countries have adopted policies that have enabled them to grow at spectacular and unheard of rates. IN THE MIDST OF THE SEVERE CURRENT RECESSION,

A M A J O R FAC TO R contributing to the successes of the past sixty years has been the liberalization of international trade. At the end of World War II, tariffs were high and nontariff barriers proliferated. Through successive rounds of trade negotiations under the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO), the average level of tariffs on manufactures in industrial countries fell from 45-50 percent in l948 to an average of about 3 percent

A tire shop iin Beijing. China lodged a complaint with WTO over tariffs imposed by Washington on its tire products.

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today. Over the same period, quantitative restrictions on imports were almost entirely dismantled, and many other barriers to trade were reduced or eliminated. While work still remains to be done, international trade in the first decade of the 21st century has been freer than at any time in world history. It is no accident that increased integration, “globalization,” in trading ties was accompanied by spectacularly successful economic growth. The world economy was in a virtuous circle: trade liberalization spurred economic growth, which in turn, made it easier for politicians to take measures for further trade liberalization. The process was facilitated by falling transport and communications costs. Of course, a great deal remains to be achieved to improve material well-being even after recovery from this recession. Poverty will still afflict many people, some countries’ living standards will have advanced only slowly, and other challenges will also persist. To address these issues, the robust growth rates that characterized the past sixty years will have to resume.

Need for further trade liberalization and resuming those growth rates will both require further liberalization of trade in goods and services in the international economy and would be retarded, if not prevented, by backsliding. Consider the benefits and opportunities that liberalized trade provides. For all countries, liberalized trade creates an economic environment in which there can be more competition than in a closed economy, and one in which domestic producers are exposed to international best practice. Either of these benefits alone raises productivity in countries with open trading regimes; imports are as beneficial in this regard as exports. Monopolists, and even comfortable oligopolists, generally produce low-quality items at high cost in their protected mar-

B U T R E C OV E RY F R O M T H E R E C E S S I O N

The Keffel container port terminal in Singapore. The nation's main exports fell at a slower pace in 2009.

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kets, and make little effort to learn about best practices in other countries. Moreover, for most poor countries, where comparative advantage lies in abundant unskilled labor, an open economy with a realistic exchange rate provides incentives for growth of export industries which can compete in international markets and employ workers. In the process, workers gain skills and, as growth continues, producers can move “up the value added chain.” This strategy has enabled the rapid growth of East Asian and other countries; no country has maintained satisfactory growth through inward-oriented development policies. The rapid expansion of trade (and falling transportation and communication costs) has enabled a “chopping up” of the value added chain as different parts and components are produced in countries where costs are lowest. This integration of production across national boundaries has resulted in major productivity gains and accelerated growth, but has also made any erection of trade barriers far more costly than in the past. A final advantage is that an open economy greatly reduces the ability of individual producing interests to influence politicians to grant them special favors. The international market is objective and performance in that market provides feedback to economic policy makers. By contrast, there is little basis on which to evaluate the performance of domestic monopolists, protected by high tariff barriers or import licensing requirements.

The threat of protectionism a double threat. It can make recovery from the recession slower than it would otherwise be. But it can also greatly reduce the growth potential of the international economy once recovery has taken hold, and especially harm the low-income countries by eliminating the opportunities for more rapid growth that outer-oriented trade strategies provide. The current threat arises because protectionist sentiments increase during recessions, along with greater pressures on politicians to heed them. However, once a protectionist measure has been taken by a country or countries, others retaliate. This has already happened to some degree in the current recession. For example, once America provided support for its automobile industry, Canada, Japan, and some European countries took similar measures to protect their own auto industries. This results in overcapacity in the industry, with sizeable costs to taxpayers and a failure of the global industry to restructure in an economically efficient way. The value of WTO rules was demonstrated earlier this year when a proposal in the American Congress to insist on a “Buy American” clause in the stimulus package was amended, under pressure, to insure consistency with the government procurement agreement negotiated under the WTO. China, not a signatory to the WTO agreement, was not so constrained. P R O T E C T I O N N OW C O N S T I T U T E S

T r a de O p e n n e s s continued on page 49

SPECIAL REPORT

The Imperative for Improved Global Economic Coordination BY JOSEPH E. STIGLITZ the policy responses, both to accelerate the recovery and to prevent a recurrence, are taking place at the national level. That is why global coordination has been strongly recommended by the UN Commission of Experts on Reforms of the International Monetary and Financial System, on which I served as chair. A LT H O U G H T H I S I S A G L O B A L C R I S I S ,

The importance of coordinating the macroeconomic response, which is the intervention needed to prevent the downturn from becoming even worse, is obvious. Each country evaluates the costs and benefits associated with the impact on its own economy. Although the costs are reflected in increased debt, a well-designed stimulus that spends money on needed investments may arguably have a negligible net cost. But because some of the extra income earned in a

Demonstrators protest against bailout funds outside of Bank of America in Washington.

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country is spent abroad, some of the value of the stimulus leaks to other countries, that is, some of the benefits accrue outside the borders. This is why the global multiplier, the ratio of the increase in global income for each dollar of government spending, is much higher than the national multiplier. Every country focuses on its national multiplier which measures the benefits that accrue internally. The result is that, without coordination, there will be too little stimulus. But matters may be even worse. Without coordination, countries will try to design their stimulus packages to maximize the national multiplier, regardless of the adverse effects on the global multiplier. For example, even if a national investment project had greater long-term benefits, the fact that it may require importing many of the critical inputs and thereby diminish the national multiplier might cause the country to choose a domestic road project instead. In an attempt to increase domestic multipliers still further, many countries have engaged in protectionist measures. Indeed within a few months of the G20 resolving not to engage in such measures, 17 of the 20 had done so. Since then, matters have only gotten worse. Such measures are likely not only to be counterproductive, since others will take retaliatory measures, but many of them also discriminate against developing countries. The “buy America” provision of the U.S. stimulus package illustrates this point. America included an exception for countries with which it had procurement agreements—mostly other developed countries. Thus, even though the developing countries are innocent victims of the failure of U.S. regulatory and macroeconomic policies, they are being in effect targeted for protectionism. Only through coordinated action can we prevent such self-destructive measures.

Developing countries are the worst hit T H E R E I S A T H I R D D I M E N S I O N of coordination. Developing countries are among the innocent victims of this crisis which is negatively affecting even many of those that did a far better job of macromanagement and regulation than the U.S. Indeed, those countries that are most closely integrated into the global economy, having followed the advice of the international economic institutions and opened themselves up the most, have been among the worst hit. Developing countries have been affected by unprecedented decreases in exports, a drop in export prices, a decline in remittances, and a decrease in capital flows—in some cases even a reversal. And they do not have the resources to protect their families who are losing their jobs or to save their businesses that are threatened with bankruptcy, let alone to provide an effective stimulus. While in the North, the crisis began in the financial sector and then moved to the real sector, in the developing countries, the crisis began in the real sector and is quickly moving into the financial, starting a vicious downward spiral. A crisis of this magnitude is certain to generate follow-on effects in the financial sector. Even banks that did a good job of credit assessment could not have anticipated a downturn of the magnitude that many countries are experiencing in, say, the export sector.

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The North has every reason to lead a coordinated global response to help the developing countries. In recent years the developing countries have been part of the world’s engine of economic growth, and it is hard to imagine a robust global recovery in which the developing countries did not play a role. A recovery in the North that was not matched by one in the South could worsen global imbalances, including trade imbalances which in turn could give rise to further protectionist pressures.

The G-20’s inadequate response the G-20 has recognized the problem. The bad news is that it has failed to respond effectively. Most of the money provided has been in the form of loans, and the primary responsibility for disbursement has been given to the International Monetary Fund (IMF). Many developing countries, just emerging from an overhang of debt, are reluctant to get back into the debt trap. Moreover, while the IMF has promised not to impose on “good countries” the counterproductive pro-cyclical conditionalities that have marked its lending in the past—and which would undermine the effectiveness of any assistance—many developing countries wonder whether they will qualify. Some of the programs, while less stringent than those of the past, still seem austere. Besides, in many developing countries there is strong domestic opposition to turning to the IMF, regardless of IMF assurances. Countries worry about losing their economic sovereignty, and in democracies, governments have to pay attention to the views of their citizens. Past IMF behavior has not earned it a great deal of affection, and many citizens are suspicious about claims of reform. As its critics inside and outside the developing countries are wont to point out, the IMF not only did not take steps to prevent the crisis but it also had pushed those deregulatory, financial, and capital market liberalization policies that played such an important role in the creation of the crisis and its rapid spread. The result is that many countries are reluctant to turn to the IMF until they have no other choice, while others are engaged in bilateral borrowing in the hope that they can “squeak” through. Global coordination of a much larger assistance program is needed, more in the form of grants and disbursed through a variety of mechanisms, as the UN expert commission urged. In short, without coordination, we are likely to have a smaller and, from a global perspective, a much more poorly designed global stimulus, resulting in a more prolonged downturn and slower recovery. Agreement on a coordinated stimulus faces several obstacles. First, there is the question of enforcement. Under current arrangements, compliance rests on good will. This may be especially problematic in presidential democracies, where parliament or congress may not support the leader’s commitment. Reaching an agreement may also be constrained by the varied circumstances in which different governments and economies find themselves. Although the United States boasts of a large stimulus, a significant fraction of Federal Government expenditure increases is being offset by expenditure reductions T H E G O O D N E WS I S T H AT

and tax increases at the state and local levels. Moreover, the United States has fewer automatic stabilizers than many European countries, with less progressive tax structures and smaller unemployment insurance systems. Similarly, practices in the private sector, which may have been influenced by government policy, also contribute less to stability. For instance, in recent years the U.S. has moved from a defined benefits pension system to a defined contributions system, which may lead to greater volatility in consumption during a crisis such as this one, as millions see their retirement accounts diminished. In light of these differences, it is difficult to ascertain what one might mean by comparable “efforts.” There may be disagreements too about whether all countries should make comparable efforts (however that might be measured). Should a country already heavily burdened by debt have to make a comparable effort as one with no inherited debt? Should richer countries have a greater obligation? Should a small open economy have a greater obligation than a large one? One might argue that the United States, with the dollar as the principal reserve currency, can borrow more easily, has a higher income and lower debt burden than many European countries, and should therefore play a proportionately larger role in the global stimulus. It could also be argued that the U.S. should take more responsibility both in stimulus and assistance to developing countries, because of the central role that its mistaken policies played in generating the crisis. Yet, so far, the U.S. has lagged behind others in offering assistance. By the same token, agreeing on what is meant by protectionism may not be easy. There are some obvious examples, such as the U.S.’s Buy America policy, mentioned earlier, and tariffs; but subsidies and guarantees are just as distortionary as tariffs. They are even more unfair, since only rich countries can afford them. Moreover, symmetric policies can have asymmetric effects: a government guarantee in a developing country is less credible than in the U.S. And if the government charges a premium for the guarantee, how can we know whether it is really at a subsidized price? The U.S. and European bailouts and bank guarantees have totally distorted the level playing field—if there ever was one. Even firms that have not received benefits can undertake riskier investments, knowing that if they have large enough losses they may be bailed out. Commitments that governments will not engage in such bailouts in the future have little credibility.

particularly disadvantageous position. Some even argue that dumping duties are a “protectionist safety valve.” I would argue that an increased use of dumping duties as advanced industrial countries appear to be doing is, in fact, protectionism. Many of the developed countries, however, view the practice as totally legitimate, while at the same time, criticizing developing countries for making use of the leeway they have between current and bound tariff rates. Of particular concern in the current crisis is financial protectionism, often associated with the massive bank bailouts. Financial market integration has meant that developed country banks play an important role, often a dominant role, in the financial markets of many developing countries. But as the crisis has heightened, some of these international banks have focused what limited lending they are willing to do on their home country, with obvious adverse effects on the developing countries. These problems are exacerbated when the government gives the bank money in the expectation of an increase in lending at home. While there has been much discussion of the consequences of financial market protectionism, little has been done.

Coordination is essential for regulation in which coordination is absolutely essential, and for many of the same reasons. The actions of one country affect another. This global crisis has very much a “made in USA” label: the U.S. exported its deregulatory philosophy and then, when all guards were down, it exported its toxic mortgages. To be sure, the U.S. economic downturn would have been far worse had it not done so, but the crisis reminds us that globalization means that both good things as well as bad things can cross borders more easily. If we are to have globally integrated financial markets, there has

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Hidden protectionism agreements contain “legal” forms of protectionism. Should all of these be acceptable under the rules of the game, or should some of them be viewed as abusive? For instance, as tariffs have come down, nontariff barriers have increased. The procedures used to determine dumping duties are not based on sound economic principles and put developing countries in a M O R E OV E R , I N T E R N AT I O N A L T R A D E

Protestors in satanic costumes at the G-20 Meltdown Protests at the Bank of England, London.

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to be some confidence that foreign institutions and financial products imported from abroad will not induce economic devastation. This can only be the case if there is coordination in regulatory policy. But not just any kind of coordination will do. The world had been moving to a common “deregulatory” framework, and this framework bears considerable responsibility for the current crisis. In the absence of such coordination, there was a risk of a race to the bottom. Financial firms told their governments that if they didn’t deregulate, they would move elsewhere. Governments, worried about the loss of jobs and revenues, gave in. Today, however, many governments are more aware of the costs of this race to the bottom. Iceland provides a telling example: its citizens, many of whom never benefited from their banks’ irresponsible behavior, will be paying the price for decades to come. Some argue that the high cost of America’s bank bail-out—with bondholders and in some cases even shareholders being protected, as the Obama Administration has created institutions that are too big to be financially resolved—is the international ramification of a collapse. But ordinary American citizens are paying a high price for a global financial system from which they benefited little. Moreover, governments with well-regulated financial institutions should rightly be wary of allowing these institutions to deal in an unfettered way with institutions from countries with inadequate regulation. They are aware that American banks sold toxic products, not just the toxic mortgages, but also dangerous derivatives. There is an obvious need for coordination in the regulatory structures so that one country can trust the products produced in another. This will require not only good regulations but effective enforcement. In the United States and elsewhere, there were regulators who didn’t believe in regulation and, not surprisingly, didn’t do a very good job in regulating. There needs to be a restoration of confidence in the entire regulatory system. It will be difficult to do this overnight. Especially discouraging are the half-hearted attempts at regulatory reform, for example in the United States. Yes, there is a move in the right direction, but is it enough? Little is being done about many of the underlying problems: banks that are not only too big to fail, but too big to be financially resolved; incentive structures that encourage short-sighted behavior and excessive risk-taking; insufficiently transparent and overly complex over-the-counter derivatives sold by banks with depository protection; inadequate restrictions on risk taking by depository institutions; too little being done about conflicts of interest; accounting standards that may even be getting worse. Indeed, some of the big banks are engaging in enhanced risk taking—to make up for the losses of the last couple of years.

Conclusion if countries cannot rely on foreign financial institutions and the products they produce, there will be a marked weakening of global financial market integration. Governments have a responsibility to protect their citizens and their economies from the dangers of financial

THE RISK IS CLEAR:

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markets. The systemic consequences of failing to do so are already too evident. Until confidence can be restored, there will have to be reliance on host country regulation. Financial products and dealings originating from under-regulated countries and even from countries with a problematic history (such as the U.S.) which “promise” to be do better in the future, will have to be carefully supervised. There will be less financial market integration, but this is part of the price we will have to pay for the failure to adequately coordinate regulatory policy in the past. While coordination is absolutely essential, success in achieving it may prove difficult. As I wrote in Making Globalization Work, economic globalization—the integration of the economies of the world especially through finance and trade—has outpaced political globalization. If we are to succeed in achieving globalization that leads to a more stable and more prosperous world for all, we will have to manage it better than we have in the past; and that means more and better coordination. Joseph E. Stiglitz is University Professor at Columbia University. He served as Chief Economist and Senior Vice President of the World Bank from 1997-2000. He was awarded the Nobel Memorial Prize in Economics in 2001. He He was also chair of the Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System.

SPECIAL REPORT

Lenders of Last Resort and Global Liquidity Rethinking the system BY MAURICE OBSTFELD balance sheet expanded sharply after the Lehman Brothers collapse of September 2008. At the end of August 2008 the United States monetary base stood at $843 billion; by the end of May 2009, the base was $1.770 trillion, more than double the earlier figure. Other central banks have also increased their balance sheets, albeit not as dramatically. In domestic financial crises, lender-of-last-resort (LLR) interventions can help contain

T H E F E D E R A L R E S E RV E SYS T E M ’ S

financial instability and are therefore a key component of the central bank’s policy arsenal. The global scope of the current financial crisis, however, is forcing a reassessment of the LLR function and the nature of liquidity shortages in a world of multiple currencies and largely unfettered cross-border financial flows. A dramatic indicator of the international scope of the crisis has been the direct extension of large-scale central bank credits to foreign central banks—in particular the Federal Reserve’s expansion of reciprocal swap lines with industrial-country and

Major newspapers heads after Lehman Brothers filed for bankruptcy and Merrill Lynch was sold to Bank of America on the same day.

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emerging-market central banks. In several cases, limits on the sizes of these swaps have been removed, allowing non-U.S. central banks such as the European Central Bank (ECB) and Swiss National Bank to supply financial markets with potentially unlimited quantities of dollars.1 Although limited Fed swap lines were created under the Bretton Woods system in 1962 and have existed in some form ever since, the recent expansion of such facilities represents an unprecedented delegation of the Fed’s powers to foreign policymakers. That development is a tacit admission that older notions of the LLR role, while suitable for an insular world characterized primarily by national finance, are ill suited to a twenty-first century environment of financial globalization.

The central banks’ interventions W H AT M OT I VAT E D T hese

central-bank policy actions? The fundamental trigger was a by-product of the process of global deleveraging set off by the Lehman collapse: a shortage of hardcurrency, especially dollar, liquidity in world financial markets. In turn, the dollar liquidity shortage—which has temporarily slowed the dollar’s long-run depreciation trend—has its roots in the international financial flows of the years 2003-07. Over the 2000s the United States has run a series of historically large annual current-account deficits. Eastern Europe also ran large deficits (relative to GDP), as did several individual countries within the European Union, including Greece, Ireland, Portugal, and Spain. These deficits were naturally offset by surpluses elsewhere. Within the industrialized world, countries such as Japan, Germany, Norway, Sweden, and Switzerland had large surpluses. Within the set of emerging and developing economies, Asia (excluding Japan), the Middle East, and the Commonwealth of Independent States ran sizable surpluses while the Western Hemisphere and African countries did the same on a smaller scale. While the causes of these imbalances remain a topic of active debate, a number of factors stand out. First, the 1997-98 Asian crisis clearly was followed by an enduring rise in savinginvestment balances throughout Asia. In some cases, countries maintained undervalued exchange rates and compressed demand to promote export-led growth, in the process accumulating large stocks of liquid international reserves, mainly dollars. One clear motive for reserve accumulation was to selfinsure against liquidity shocks rather than depend on the International Monetary Fund as in past crises. Whatever the causes—the details differ from country to country—a consequence of the increase in desired Asian surpluses was a downward pressure on world interest rates and price levels. But it takes two to tango, and both policy as well as institutional responses in the industrialized world led to a significant magnification of the volume of world financial flows. The collapse of the dot-com bubble, followed by the 9/11 attacks, led the Federal Reserve and other central banks to lower interest rates. Japan remained in the grip of a seemingly intractable deflation. Discerning a similar potential in the U.S. economy, the Fed held interest rates quite low until embarking on a gradual tightening cycle in mid-2004. Low industrial-country

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interest rates helped to inflate commodity prices, notably the price of oil, helping to fuel the increased Russian, Middle Eastern, and Latin American external surpluses. This international income transfer that may have put further downward pressure on world interest rates, as during the oil boom of the 1970s, which was prologue to the 1980s debt crisis. Low interest rates and booming commodity prices during the mid-2000s contributed to a prolonged period of tranquility for emerging markets. Many began to question the ongoing need for the International Monetary Fund (IMF), as that institution shrank under pressure of reduced lending revenues. As is now evident, however, emerging markets were benefiting from an exceptionally favorable but temporary constellation of external forces. Finally, low interest rates had a dramatic effect on real estate prices. Low interest rates and the availability of cheap foreign finance, interacting with distortions in markets for housing finance, fueled dramatic house-price appreciation. Higher levels of housing equity eased households’ liquidity constraints and supported high consumption levels and reduced levels of private saving out of GDP. While similar effects were seen in many other countries—there is a high statistical correlation over the 2000s between real estate appreciation and current account deficits—the United States was the epicenter of the financial innovations and practices that sparked the collapse of 2007-08. This fact led to one of the ironies of the financial crisis: although several analysts had worried up until 2007 that a U.S. housing collapse might signal a compression of the U.S. external deficit and a collapse in the dollar’s value, the housing collapse, at several stages of the crisis, actually led to an apparent shortage of dollars.

The European banks and the dollar starting in August 2007 was European banks’ high propensity to invest in U.S. dollar assets over 2003-07. Initially around $4 trillion in 2003, European banks’ U.S. dollar assets exceeded $8 trillion by the first quarter of 2007.2 These banks drew short-term dollar funding from the interbank market, and also borrowed nondollar currencies, swapping these funds into dollars on a short-term basis, to hedge their long dollar positions.3 European banking flows into the U.S. were invested heavily in AAA-rated tranches of securitized assets such as subprime mortgage pools. The high credit ratings of these structured products reflected low expected loss, but ignored portfolio risk. In fact, the assets carried significant systematic risk due to the likelihood of default precisely when all global asset markets would be melting down simultaneously. In addition to expected return, these structured products carried an important collateral benefit. By holding them instead of assets subject to idiosyncratic risk and therefore with lower credit ratings, banks were able to reduce required regulatory capital ratios. The result was regulatory arbitrage on a large scale.4 European banks’ need to fund their U.S. purchases through short-term dollar borrowing made them susceptible to any reduced availability of dollar liquidity. This is what happened in ONE REASON FOR THE DOLLAR SHORTAGE

August 2007, and even more dramatically in September 2008. Interbank markets seized up, foreign exchange swap markets became illiquid, and U.S. money-market funds faced a run in the fall of 2008 and retracted their foreign dollar lending.5 Central-bank withdrawals during 2007-08 of dollar reserves that had been placed in commercial banks didn’t help.6 On top of funding illiquidity, banks faced market illiquidity as they attempted to sell their toxic assets. The ECB initially had the tools to provide euro liquidity, but not dollar liquidity. European institutions needing dollars, but lacking access to the Fed through U.S. affiliates, sold euros for dollars on the foreign exchange market. The result of these aggregate sales was upward pressure on the dollar and a relatively weaker euro. As a response, the central bank swap arrangements for dollars were set up starting in December 2007. Since that date the Fed has acted as a global LLR for dollars. It has done so by subcontracting its LLR function (along with its

An angry investor in Singapore, who lost his savings, urges the central bank to help him recover his money.

monopoly on money creation) to a selected set of foreign central banks. These arrangements have been ad hoc and explicitly temporary. Most likely, more limited swap facilities will be maintained into the future—as in the past—with the option (at the currency issuer’s discretion) for greater flexibility in times of crisis. To the extent that nondollar currencies such as the euro and (eventually) the renminbi could be in short supply during future financial breakdowns, there is a strong case for crisis-elastic sources of those currencies as well. Even the central banks and treasuries of industrial countries may choose to accumulate larger stocks of liquid foreign-currency reserves, easily available for lending during episodes of turbulence.

The systematic approach of the crisis, however, is the need to take a systemic view of measures aimed at financial stability. As numerous observers of the recent crisis have noted, measures that enhance the stability of a single institution, viewed in isolation, could be inimical to the stability of the financial system as a whole. There is a fallacy of composition, for example, in asking financial institutions to augment their capitalasset ratios in a crisis: a fire-sale externality could destabilize all institutions as each one scrambles to unload assets in illiquid markets. A similar point applies to national efforts to self-insure through increased holdings of liquid international reserves: when a country draws down its dollar reserves held abroad, that action might well have price or liquidity effects that increase financial instability abroad. This is a familiar theme from timehonored textbook examples of coordination failures in reserve management ranging from the scramble for gold in the interwar years to the Triffin problem. But the basic insight remains relevant, in a different form, today. The implication is that the world economy needs lenders of last resort capable of creating and providing true outside liquidity. The enhanced swap lines provided by the Fed starting in 2007 were indeed a source of outside dollar liquidity. Going forward, however, it seems impractical and politically problematic for national central banks to subcontract emergency lending over the long term on what is essentially a bilateral basis. A more efficient solution would centralize last-resort lending of foreign currencies in an institution whose operations would ideally approximate the outcome of a cooperative equilibrium among policymakers. The practical obstacles to designing and establishing such an institution, ranging from the need for broad international political support to the limitation of moral hazard, are daunting. To start, an international LLR, if not endowed with supranational regulatory powers itself, would at least need ready access to accurate, up-to-date, and internationally consistent data on the health of member countries’ financial sectors. It is inadvisable for any LLR to delegate its functions blindly. The current difficulty of agreeing an enhanced regulatory framework even among European Union countries offers a sobering counterpoint on the possibilities for even broader international regulatory cooperation. Nonetheless, the need for progress is urgent. O N E I M P O RTA N T L E S S O N

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At the moment, the International Monetary Fund—itself the improbable product of a visionary postwar exercise in international political cooperation—is the closest thing we have to an international LLR.7 The IMF has the capacity not only to create outside liquidity, but also to channel inside liquidity agents with relatively ample liquidity to markets in which liquidity is scarce. IMF quotas represent outside liquidity. When Pakistan borrows dollars from the IMF, for example, the dollars come from an IMF account at the Federal Reserve. If the IMF borrows dollars from the government of Japan’s reserves, however, liquidity may simply be reallocated, not created. In a crisis situation, even such liquidity reallocation by the Fund can help stave off economic disaster for the borrower. A major structural advantage of the IMF is that it can create liquidity in alternative national monies, thereby meeting potential shortages of nondollar currencies. In recent decades the IMF has intervened almost exclusively with emerging and developing countries. It seems likely that for some time, the IMF will continue to focus on the group of less prosperous countries, with the LLR needs of richer countries met through ad hoc bilateral or even multilateral arrangements of the type seen recently. It is not inconceivable, however, that the IMF’s role could someday extend, as in the past, to the richer countries. Indeed, this development seems natural in a world where the current emerging economies are evolving toward eventual economic and political parity with the current group of industrial economies. Enhancing the IMF’s lending capacity has rightfully been high on the agenda of policymakers seeking to address the global financial crisis. Equally important, however, have been moves to reform the political governance of the IMF in a way that recognizes the increasing importance of the developing countries in the world economy. Much remains to be done, especially in the sphere of international regulatory reform, and the difficulties cannot be overstated. Nonetheless, the recent global financial crisis has underlined both the importance and the nontraditional nature of the lender-of-lastresort function in a financially globalized world characterized by multiple national currencies. As the twenty-first century unfolds, the IMF seems certain to be an increasingly important player in performing that function. Maurice Obstfeld is Professor of Economics at the University of California, Berkeley. References Acharya, Viral V. and Phillipp Schnabl. “How Banks Played the Leverage Game.” In Viral V. Acharya and Matthew Richardson, editors, Restoring Financial Stability: How to Repair a Failed System. New York: John Wiley & Sons, 2009. Baba, Naohiko, Robert N. McCauley, and Srichander Ramaswamy. “US Dollar Money Market Funds and Non-US Banks.” BIS Quarterly Review (March 2009): 65-81. Baba, Naohiko, Frank Packer, and Teppei Nagano. “The Spillover of Money Market Turbulence to FX Swap and Cross-Currency Swap Markets.” BIS Quarterly Review (March 2008): 73-86. Fischer, Stanley. “On the Need for an International Lender of Last Resort.”

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Journal of Economic Perspectives 13 (Fall 1999): 85-104. McGuire, Patrick and Goetz von Peter. “The US Dollar Shortage in Global Banking.” BIS Quarterly Review (March 2009): 47-63. Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor. “Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008.” American Economic Review Papers and Proceedings 99 (May 2009): 480-486. Endnotes 1 For description and further references, see Obstfeld, Shambaugh, and Taylor (2009). 2 See Baba, McCauley, and Ramaswamy (2009), p. 66. 3 See McGuire and von Peter (2009). 4 See Acharya and Schnabl (2009). 5 See Baba, Packer, and Nagano (2008) and Baba, McCauley, and Ramaswamy (2009). 6 See McGuire and von Peter (2009), p. 57. 7 Ten years ago Fischer (1999) made this case in detail. It is impossible to do justice to the arguments pro and con in the space available here.

SPECIAL REPORT

The Dollar Dilemma BY BARRY EICHENGREEN N OT A F E W O B S E RV E R S H AV E A S S E RT E D that the dollar’s prospects as a reserve currency have been dimmed by the crisis of 2007-2009. The crisis has diminished the attractiveness of the United States as a supplier of high-quality financial assets, but at the same time has ensured that the U.S. will be issuing vast quantities of public debt for the foreseeable future. Together these trends in supply and demand imply a weaker dollar. The resulting capital losses on central banks’ outstanding dollar reserves will in due course cause them to consider alternatives. There is only one problem with this argument: there has been no actual diminution of the dollar’s international role. For evidence we need look only to the foreign exchange market, where the dollar in fact became stronger following the outbreak of the crisis, as domestic and foreign investors fled to the safety of U.S. treasuries.

Why the crisis prompted this flight toward the dollar rather than away from it is clear. The U.S. treasury market has unrivaled liquidity which is a key attraction for central banks. Reserve instruments not readily convertible into cash are not easily deployed in market operations so it matters critically to reserve managers that the market in US treasuries is the most liquid in the world. This makes it difficult for other currencies to compete.

The rise of the euro are not especially attractive. The pound sterling and Swiss franc each account for less than 2 percent of global reserves, reflecting the small size of their issuing economies. The yen accounts for barely 3 percent, reflecting Japan’s past policies of discouraging the currency’s internationalization and more recently, the country’s “lost decade” and extended period of zero interest rates.

T H E A LT E R N AT I V E S T O T H E D O L L A R

And the winner is...

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The only serious alternative is the euro. The euro area possesses the requisite scale, and also has a large government debt market. But its various government bonds differ in their risk, returns, and liquidity. German government bonds have a reputation for stability, but the market for these bonds lacks liquidity since they tend to be held to maturity by institutional investors. Italian government bonds are the most important euro area debt securities in value, but are not attractive as reserve assets because of the country’s economic problems. Nevertheless, as neighboring countries forge deeper links with the EU, they are likely to hold more euros. For example, recognizing the growing importance of European trade and finance, Russia recently increased the weight of the euro in the basket of currencies used to guide its exchange rate policy. As the euro becomes more important to Russia as a reference currency, its central bank will want to hold a larger share of its reserves in euro-denominated securities. In its 2008 annual report the Central Bank of the Russian Federation confirmed that it had reduced the share of dollars in its reserves from 47 to 41.5 percent between the beginning of 2008 and the beginning of 2009 and raised the share of the euro from 42.4 to 47.5 percent. In June it indicated that it intended to reduce still further the share of dollar-denominated assets in its portfolio. This case illustrates that there is likely to be some further reallocation of reserves from dollars to euros by the countries on Europe’s periphery. The euro will become an increasingly important reserve currency in that part of the world. Whether it can surpass the dollar globally, given the greenback’s head start and the euro area’s own unfavorable demographics, is another matter.

The China dollar paradox R U S S I A ’ S R E S E RV E D I V E R S I F I C AT I O N is one thing, but reserve diversification by China is another matter. Informed guesses put China’s official dollar assets at roughly eight times Russia’s as of May 2009. Thus reserve diversification by China would be a very big deal. It is not surprising that the issue has become a flashpoint domestically since China’s foreign currency reserves amount to $2,000 per Chinese resident. That said, Chinese officials are aware that they are trapped. The prices of treasuries would tank if the People’s Bank of China sold them in sufficient quantities to significantly alter the currency composition of its reserve portfolio. To the extent that dollars still comprised a significant portion of its reserves, the People’s Bank would incur costly losses. One is reminded of Keynes’s aphorism: “When you owe your bank manager a thousand pounds you are at his mercy. When you owe him a million pounds, he is at your mercy.” The sensible strategy in such circumstances would be to make a series of small adjustments in portfolio proportions, which is essentially what China’s reserve managers are doing. This is yet another reason why the declining dominance of the dollar in reserve portfolios is more likely to be gradual than sudden. Finding itself in this bind, China has, not unreasonably, begun exploring other options. In March 2009 its central

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bank governor made a splash by arguing that the IMF’s Special Drawing Rights (SDRs) should replace the dollar as the world’s reserve currency. The obstacles to making this happen are formidable. Reserves, as noted above, are only attractive if they can be used. Making the SDR attractive would thus require developing markets on which SDR claims can be bought and sold. It would be necessary to build a market on which governments could issue SDR bonds at a competitive cost. Banks would have to find it attractive to take SDR deposits and make SDR loans. It would be necessary to restructure foreign exchange markets so that traders went through the SDR. Making this happen would require significant investments over an extended period. To start with, if China were serious about elevating the SDR to reserve-currency status, it should then take steps to create a liquid market in SDR claims. For example, it could issue SDR-denominated bonds. This would be a much more meaningful step than buying SDR bonds from the IMF, as it has indicated it will do. Then there is the question of who would be on the demand side of the market. Government bonds are held by pension funds and insurance companies since the maturity of the bonds matches the maturity of these buyers’ liabilities. If the dollar depreciated against the euro, a European insurance company holding SDR-denominated bonds and eurodenominated liabilities would find itself in deep trouble. Potential investors would need markets on which to hedge SDR currency risk—markets that can only be created at a cost. Finally, for the SDR to become an attractive form of reserves, the IMF would have to be able to issue additional SDRs in periods of shortage, much as the U.S. Federal Reserve provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008. In other words, for the SDR to become a true international currency, the IMF would have to become more like a global central bank. Again, this is unlikely to happen overnight.

An international Chinese currency? for discounting the SDR proposal is that China has a preferred alternative: establishing the renminbi as an international currency. If the renminbi were to be widely used in international transactions, China itself would no longer need to hold foreign currencies to smooth its balance of payments. It could simply print more or less of its own currency, as necessary, like the United States. But for now the renminbi remains unconvertible. Foreigners can only use it to purchase goods from China. It is used in cross-border trade only with China’s immediate neighbors. Brazil and China recently announced the intention to explore ways of using their own currencies in their bilateral trade. But this agreement is mainly useful for advertizing Chinese-Brazilian trade. A Brazilian firm will take renminbi in payment for its exports only to the extent that it imports from China—not your typical case. Similarly, China’s recently concluded swap agreements with Argentina, Belarus, Hong Kong, Indonesia, South Korea

P E R H A P S T H E M O S T F U N DA M E N TA L R E A S O N

and Malaysia are mainly a way of signaling its global ambitions. These countries cannot use renminbi to intervene in foreign exchange markets. They cannot use it to import merchandise from third countries or to pay foreign banks and bondholders. In time, China can strengthen the international role of the renminbi by developing liquid financial markets and liberalizing foreigners’ access to these markets. Over time, it can also make its currency convertible for financial as well as merchandise transactions. The question is: how much time? Reconciling financial stability with capital account convertibility has formidable prerequisites. Markets must first become more transparent. Banks must be commercialized. Supervision and regulation must be strengthened, and the exchange rate must be made more flexible to accommodate a larger volume of capital flows. China, in other words, must first move away from a growth model in which bank lending and a pegged currency have been two of the pillars of its development policy. This is easier said than done. Witness how the Chinese authorities’ reaction to the crisis was in fact to move in the other direction, relying more on directed lending to boost investment and hardening the renminbi’s peg to the dollar to sustain exports. The year 2020 is the authorities’ target date for transforming Shanghai into an international financial center and thus, de facto, for the capital account convertibility that is a prerequisite for a reserve-currency role for the renminbi. But even if China grows at a 7 percent annual rate for the next decade (slower than in the past, reflecting less favorable demographics, but still exceptional), its GDP in 2020 will still be considerably smaller than that of the U.S. at market exchange rates. The renminbi will still have a smaller domestic platform than the dollar. In turn this means that its market liquidity will not be comparable. Under these circumstances, the attractiveness of holding reserves in renminbi will be limited. It will be most attractive to countries conducting the majority of their trade with China and doing their international financial business in Shanghai. This suggests that the market for renminbi reserves will, at least initially, be concentrated in Asia, much as the market for euro reserves is concentrated in Europe.

The resilient dollar I C O N C L U D E , BY P R O C E S S O F E L I M I N AT I O N , that the dollar will remain the principal form of international reserves for the foreseeable future. It will not be as dominant as in the past, for the same reasons that the United States will not be as dominant economically as in the past. In the short run the euro will continue to gain market share, especially in Greater Europe. In the longer run there will be a role for the renminbi, especially in Greater Asia. But as far into the future as I personally am able to see, the dollar will remain first among equals.

T r a de O p e n n e s s continued from page 38

When countries try to protect their own industries, any short-run gains in a given industry are generally offset by losses in others; and industries using imports of the protected goods either face higher costs of production or must develop higher-cost domestic supply sources). The global economy is worse off as a result of reduced productivity and output. This happened in the l930s, when the Smoot-Hawley tariff passed by the American Congress erected high tariff barriers in the United States. Other countries retaliated and international trade shrank by an even greater proportion than world GDP during the Great Depression. Economic historians blame the high tariff barriers that were erected in the U.S. and elsewhere as being a major contributing factor to the length and severity of the Great Depression. Because of the increased integration of the world economy, the costs of protection today would be even greater than they were in the l930s. Politically it is relatively easy to erect protective barriers, but difficult to remove them. World output will be lower and the recession somewhat deeper if countries become more protectionist. But the real question is how soon and how rapid the upturn and the return to global economic growth will be. And it is here that the dangers of protection are worst: if exporters everywhere are confronted with trade barriers, they will not invest in additional capacity to the same extent as they would in a more open global system, and resources will remain stuck in industries (such as autos and steel) where excess capacity exists and there is little incentive for further investment. In such a post-recession world, poor countries’ prospects for growth through an outer-oriented trade strategy would still be better than if they were to adopt protectionist barriers, but less favorable than if the world returned to an open, liberal, multilateral trading system. Policy makers’ concerns about the short run and the temptation of protectionism are understandable. But protectionism will invite retaliation and, once started, will increase pressures and temptations for even more protectionism. Policy makers can reduce the threat by reviving and completing the Doha Round of multilateral trade negotiations under the WTO. Such an action would strengthen the open multilateral trading system, serve as a barrier against further protection (especially by reassuring those who argue for protection because “others will do it”), and provide producers with appropriate signals that it is safe to invest in export industries because they will still be operating on level playing fields. Anne O. Krueger is Professor of International Economics, SAIS, Johns Hopkins University and Senior Fellow and Professor Emeritus,

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor

Stanford University.

of Economics and Political Science at the University of California, Berkeley.

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SPECIAL REPORT

Government Actions and Interventions More harm than good? BY JOHN B. TAYLOR I N T H E S U M M E R O F 2 007 at the annual Jackson Hole international conference for central bankers and financial officials I provided evidence that excessively low interest rates set by the United States Federal Reserve in 20032005 was a primary cause of the housing boom and subsequent housing bust which eventually led to the financial crisis. The article by Carmen Reinhart in this issue delves deeper into this argument. Here I review evidence that other government actions taken in 2007 and 2008 unfortunately prolonged and worsened the crisis.

Prolonging the crisis became acute on August 9 and 10, 2007 when money market interest rates rose dramatically. Figure 1 illustrates this, using the spread between the three-month Libor and the three-month Overnight Index Swap (OIS). The OIS is a measure of what the markets expect the federal funds rate to be compared to the three month Libor over the three-month period. Subtracting OIS from Libor effectively controls for expectations effects which are a factor in all term loans, including the three-month Libor. The difference between Libor and OIS is thus due to factors other than interest rate expectations, such as risk and liquidity effects.

THE FINANCIAL CRISIS

Community activists demonstrate at the Federal Bankruptcy Courthouse in Santa Barbara, California.

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FIGURE 1: THE LIBOR–OIS SPREAD DURING THE FIRST YEAR OF THE CRISIS

FIGURE 2: COUNTERPARTY RISK EXPLAINED MOST OF THE VARIATION

Source: “A Black Swan in the Money Market,” (with John C. Williams), American Economic Journal: Macroeconomics, Vol.1, No.1, January 2009, pp. 58-83.

Source: Author’s calculations based on research [3] in the references.

FIGURE 3: THE TERM AUCTION FACILITY HAD LITTLE IMPACT ON THE SPREAD

Source: “A Black Swan in the Money Market,” (with John C. Williams), American Economic Journal: Macroeconomics, Vol.1, No.1, January 2009, pp. 58-83.

Looking at the lower left of Figure 1 you see that on August 9th and 10th of 2007 this spread jumped to unusually high levels. Bringing this spread down was a major objective of monetary policy from the start of the crisis.

Diagnosing the problem: Liquidity or counterparty risk? D I AG N O S I N G T H E R E A S O N for the increased spreads was essential to determining the appropriate policy response. If it was a liquidity problem then providing more liquidity by making discount window borrowing easier or opening new windows or facilities would be appropriate. But if the issue was counterparty risk then a direct focus on the quality and transparency of the bank’s balance sheets would be appropriate.

To assess the issue empirically, one can look at the difference between interest rates on unsecured and secured interbank loans of the same maturity. Examples of secured loans are government-backed Repos between banks. By subtracting the interest rate on Repos from Libor, you get a measure of risk. Figure 2 shows the high correlation between the unsecured-secured spread and the Libor-OIS spread. There seemed to be little role for liquidity. These results suggest, therefore, that the market turmoil in the interbank market was not a liquidity problem of the kind that could be alleviated simply by central bank liquidity tools. Rather it was inherently a counterparty risk issue. But this was not the diagnosis that drove economic policy during this period. Rather the early interventions focused on liquidity. As evidence I provide three examples of interventions that prolonged the crisis either because they did not address the problem or because they had unintended consequences.

Term Auction Facility TO M A K E I T E A S I E R F O R B A N K S to borrow from the Fed, the Term Auction Facility (TAF) was introduced in December 2007. Similar facilities were set up at other central banks. The main aim of the TAF was to reduce the spreads in the money markets and thereby increase the flow of credit and lower interest rates. Figure 3 shows the amount of funds taken up (on the right scale) along with Libor and OIS spread (on the left scale). Clearly, the TAF did not make much difference.

Temporary cash infusions through the 2008 Fiscal Stimulus A N O T H E R E A R L Y P O L I C Y R E S P O N S E was the Economic Stimulus Act of 2008 passed in February, which sent cash totaling over $100 billion to individuals and families in the

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FIGURE 4: THE REBATES INCREASED INCOME, BUT NOT CONSUMPTION. (MONTHLY DATA, SEASONALLY ADJUSTED, ANNUAL RATES).

Source: Authorâ€™s calculations based on research [4] in the references.

United States so they would have more to spend and thus jump-start consumption and the economy. Most of the checks were sent in May, June, and July. However, people spent little if anything of the temporary rebate, and consumption was not jump-started. The evidence is in Figure 4. The top line shows how personal disposable income jumped at the time of the rebate. The lower line shows that personal consumption expenditures did not increase.

FIGURE 5: THE SHARP CUT IN INTEREST RATES WAS ACCOMPANIED BY A RAPID INCREASE IN OIL PRICES THROUGH THE FIRST YEAR OF THE CRISIS. (LAST OBSERVATION IS JULY 2008)

Source: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press, Stanford, 2009.

FIGURE 6: EVIDENCE OF THE CRISIS WORSENING DRAMATICALLY FOURTEEN MONTHS AFTER IT BEGAN

The initial sharp cuts in interest rates through April 2008 was the sharp reduction in the federal funds rate. The federal funds rate target went from 5.25 percent when the crisis began, to 2 percent in April 2008. The so-called Taylor rule also called for a reduction in the interest rate during this early period, but not as sharp as the federal funds rate. The most noticeable effects of the cut in the federal funds rate, were the sharp depreciation of the dollar and the large rise in oil prices. During the first year of the financial crisis oil prices doubled from about $70 per barrel in August 2007 to over $140 in July 2008, before plummeting back down as expectations of world economic growth declined sharply. Figure 5 shows the close correlation between the federal funds rate and the price of oil during this period using monthly average data. The chart ends before the global slump in demand became evident and oil prices fell back. Clearly this bout of high oil prices hit the economy hard as gasoline prices skyrocketed and automobile sales plummeted in the spring and summer of 2008. When it became clear in the fall of 2008 that the world economy was turning down sharply, oil prices then returned to the $60-$70 range. But by this time the damage caused by the high oil prices had been done. A THIRD POLICY RESPONSE

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Source: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press, Stanford, 2009.

The crisis worsens in the panic of the fall of 2008 F I G U R E 6 S H OWS how dramatically the financial crisis worsened in October 2008. Many commentators have argued that the reason for the worsening of the crisis was the U.S. governmentâ€™s decision not to intervene to prevent the Lehman Brothers bankruptcy on the weekend of September 13 and 14. The timing of events suggests that the answer is more complicated than this and, in my view, lies elsewhere. Figure 7 focuses on a few key events from September 1 through mid October. Since then conditions have improved as the graph illustrates. But the question here is what led to the worsened conditions. You can see that the spread moved a bit on September 15th, which is the Monday after the weekend

FIGURE 7: EVENT STUDY OF THE DRAMATIC WORSENING OF THE CRISIS

Source: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press, Stanford, 2009.

that conditions were much worse than many had been led to believe. At a minimum, the rollout of the TARP revealed a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, and thereby added to business and investment decisions at that time. Such uncertainty would have driven up risk spreads in the interbank market and elsewhere. This lack of predictability about Treasury-Fed intervention policy and recognition of the harm it could do to markets likely increased in the fall of 2008 when the underlying uncertainty was revealed for all to see. What was the rationale for intervening with Bear Stearns, and then not with Lehman, and then again with AIG? What would guide the operations of the TARP? Worries about the lack of clarity were raised in many quarters. At a conference held at Stanford in July to address the new interventions, I argued that the U.S. Treasury and the Fed urgently needed to develop a new framework for exceptional access to government support for financial institutions. The more policy makers could articulate the rationale and the procedures the better.

Conclusion decision not to intervene in Lehman Brothers. It then dropped back down a little on September 16 around the time I N T H I S A RT I C L E I have provided empirical evidence that of the AIG intervention. While the spread did rise during the government actions and interventions prolonged and worsweek following the Lehman Brothers decision, it was not far ened the financial crisis. They prolonged it by misdiagnosing out of line with the events of the previous year. the problems in the bank credit markets and thereby respondOn Friday of that week the Treasury announced that it ing inappropriately by focusing on liquidity rather than risk. would propose a large rescue package. The package was put They made it worse by providing support for certain financial together over the weekend and on Tuesday September 23, institutions and their creditors but not others in an ad hoc way Federal Reserve Board Chairman Ben Bernanke and Treasury without a clear and understandable framework. While other Secretary Henry Paulson testified in Congress that the packfactors were certainly at play, these government actions should age would be $700 billion. They provided a two and a half page be first on the list of reasons for what went wrong. draft of the legislation, specifying little oversight and few What are the implications of this analysis? Most important is restrictions on its use. They were that government fiscal and monquestioned intensely and the etary policy interventions, howpublic reaction was quite negaever well-intentioned, can make tive, judging by the large volume things worse if they are based on of critical mail received by many faulty diagnosis of the problem members of the United States and do not follow clear preCongress. As shown in Figure 7 it dictable principles. Establishing was following this testimony that a set of principles to follow will one really begins to see the crises help prevent such misguided deepening. actions and interventions. The main message in Figure 7 is that it is questionable to identiJohn B. Taylor is Mary and Robert fy the decisions of the weekend of Raymond Professor of Economics at September 13 and 14 as having Stanford University and Bowen H. increased the severity of the criand Janice Arthur McCoy Senior sis. Not until more than a week Fellow at the Hoover Institution. later did conditions deteriorate. This essay is drawn from John B. Taylor, Moreover, it is plausible that Getting Off Track: How Government events around September 23 Actions Caused, Prolonged, and actually drove the market, includWorsened the Financial Crisis, Hoover ing the realization by the public Press, Stanford, California, 2009. Artist Laura Gilbert's "The Bailout Bill." Gilbert created an that the intervention plan had not edition of 5000 copies to give away. been fully thought through and

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KNOWLEDGE RESOURCES

THE WORLD BANK E-LIBRARY is an electronic

portal to the Bank’s full-text collection of books, reports, and other documents. A commercial, subscriptionbased research and reference tool, the World Bank eLibrary brings together, in a fully indexed and crosssearchable database, more than 1,000 titles published by the World Bank during the past several years, plus every new title as it is published. Subscribers have the option of including access to the World Bank’s two statistical databases, World Development Indicators (WDI Online) and Global Development Finance (GDF Online). www.worldbank.org/elibrary

CABI is a not-for-profit

international organization that improves people’s lives by providing information and applying scientific expertise to solve problems in agriculture and the environment. Our mission and direction is influenced by our member countries who help guide the activities we undertake. These include scientific publishing, development projects and research, and microbial services. http://www.cabi.org

EUROPEAN INVESTMENT BANK (EIB) furthers the

objectives of the European Union by making long-term finance available for sound investment. We provide service and value-added through our appraisal and follow-up of investment projects and programs. To receive our support, projects and programs must be viable in four fundamental areas: economic, technical, environmental and financial. We appraise each investment project thoroughly and follow it through to completion. http://www.eib.org

EUROPEAN FORUM ON INTERNATIONAL COOPERATION (EUFORIC)

makes information on Europe’s international cooperation more accessible; facilitates communication and dialogue among organizations involved in Europe’s international cooperation; and

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brokers collaboration, learning and knowledge exchange on international cooperation issues. Euforic is a not for profit cooperative, owned and guided by its members. These members are a richly diverse mix of NGOs, research institutes, educational institutions, networks, governments, and other interested groups. www.euforic.org

THE GAVI ALLIANCE is a

global health partnership whose members work together to achieve a goal no agency could reach alone: save lives by increasing access to vaccines. Partnership representing stakeholders in immunization from both private and public sectors. GAVI represents stakeholders in immunization from both private and public sectors: developing world and donor governments, private sector philanthropists, the financial community, developed and developing country vaccine manufacturers, research and technical institutes, civil society organizations and multilateral organizations. www.gavialliance.org

AITIC is an intergovernmental

organization, based in Geneva. Its goal is to assist less-advantaged countries (LACs, i.e. resource-constrained developing countries and economies in transition, with a priority to the least-developed countries) to have more effective tradeled growth through personalized assistance and capacitybuilding programs. AITIC provides the LACs with information and policy advice to help them integrate into the multilateral trading system and the work of the WTO and other international trade-related organizations. www.acici.org/aitic

COOPERATION FOR PEACE AND UNITY (CPAU) is an Afghan

not-for-profit research think tank and an institution working for the promotion of knowledge and awareness of peace, social justice and human rights as the foundation upon which the future development of Afghanistan will be built. We welcome you to our official site and wish you find contents and material useful. www.cpau.org.af

BOOKSHELF

TOO BIG TO FAIL: The Inside Story of How Wall Street and Washington Fought to Save the Financial System— and Themselves, by Andrew Ross Sorkin.

Viking Adult, 2009. Andrew Ross Sorkin delivers the first true behind-the-scenes, moment-bymoment account of how the greatest financial crisis since the Great Depression developed into a global tsunami. From inside the corner office at Lehman Brothers to secret meetings in South Korea, and the corridors of Washington, Too Big to Fail is the definitive story of the most powerful men and women in finance and politics grappling with success and failure, ego and greed, and, ultimately, the fate of the world’s economy.

THE IDEA OF JUSTICE, by Amartya Sen,

Belknap Press of Harvard University Press, 2009. Social justice: an ideal, forever beyond our grasp; or one of many practical possibilities? At the heart of Sen’s argument is a respect for reasoned differences in our understanding of what a “just society” really is. People of different persuasions might each reasonably see a clear and straightforward resolution to questions of justice; and yet, these resolutions would be completely different. In light of this, Sen argues for a comparative perspective on justice that can guide us in the choice between alternatives that we inevitably face.

THIS TIME IS DIFFERENT: Eight Centuries of Financial Folly, GLOBAL DEVELOPMENT FINANCE,

The World Bank, 2009. Global Development Finance—the World Bank's annual report on the external financing of developing countries—provides monitoring and analysis of development finance, identifying key emerging trends and policy challenges in international financial flows that are likely to affect the growth prospects of developing countries. Over the past two years, the world has seen turmoil in a relatively small segment of the U.S. credit markets morph into a severe global economic and financial crisis. Although aggressive monetary policy, fiscal stimulus, and guarantee programs to shore up the banking industry have begun to stabilize financial markets and slow the pace of economic contraction, policy makers face an extended battle to revive the global economy.

INVESTING WITH CONFIDENCE: Understanding Political Risk Management in the 21st Century, edited

by Gero Verheyen, Srilal M. Perera and Kevin W. Lu. The World Bank, 2009. Coinciding with the Multilateral Investment Guarantee Agency's (MIGA) twentieth anniversary, this book examines key political risk issues including claims and arbitration, perspectives on pricing from the private, public and multilateral providers, as well as exploring new frontiers in sovereign wealth funds and Islamic finance.

by Carmen M.Reinhart and Kenneth S. Rogoff. Princeton University Press, 2009. Throughout history, rich and poor countries alike have been lending, borrowing, crashing, and recovering their way through an extraordinary range of financial crises. Each time, the experts have claimed that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters —“this time is different.” This book proves that premise wrong. Covering sixty-six countries across five continents, it presents a comprehensive look at the varieties of financial crises, and guides us through eight astonishing centuries of government defaults, banking panics, and inflationary spikes.

MOVING OUT OF POVERTY: The Promise of Empowerment and Democracy in India, by Deepa Narayan.

Palgrave Macmillan, 2009.

India has experienced accelerating growth in the last decade, yet why do millions of people remain mired in poverty? This book brings together the voices of the poor from 300 villages in the Indian states of Andhra Pradesh, Assam, Uttar Pradesh, and West Bengal, during the decade from 1995 to 2005. It documents the entrepreneurialism of the poor, arguing that responsive local government, when combined with access to information, market access and collective action, can do much to facilitate poor people’s movement out of poverty.

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CALENDAR NOVEMBER 2009

JANUARY 2010

Nov 30– Dec 2

27–31

Seventh WTO Ministerial Conference Geneva, Switzerland www.wto.org

World Economic Forum Annual Meeting Davos-Klosters, Switzerland www.weforum.org

DECEMBER 2009

FEBRUARY 2010

1–3

18–20

Routes out of the Crisis: Strategies for Local Employment Recovery and Skills Development in Asia Malang (Java), Indonesia www.ilo.org

7–18

Migration: A World in Motion. A Multinational Conference on Migration and Migration Policy University of Maastricht, Maastricht, Netherlands www.appam.org/conferences/international/ maastricht2010/index.asp

United Nations Climate Change Conference Copenhagen, Denmark

MARCH 2010

http:/en.cop15.dk 19–21 11–12

Institute for the Study of Labor, IZA Workshop: Unemployment Insurance and Flexicurity Bonn, Germany

2nd Annual Meeting on the Economics of Risky Behaviors (AMERB) Stone Mountain, Georgia, USA www.iza.org

www.iza.org APRIL 2010 12–13

2009 International Symposium on Contemporary Labor Economics Xiamen University, Xiamen, China

10–11

www.wise.xmu.edu.cn/Labor2009

The Third International Forum on the Rights of Persons with Disabilities Hilton Hawaiian Village, Honolulu. Hawaii www.pacrim.hawaii.edu

12–13

The 26th Pacific Rim International Conference on Disabililties Hawaii Convention Center, Honolulu, Hawaii www.pacrim.hawaii.edu

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