Financial Crisis

In today’s globalized world, no country is immune from the crisis. Even if some countries do not have the financial market exposure that would affect them in the first round of the crisis, the slowdown in economic growth which is affecting all major economies will affect Africa since commodity prices will fall, export markets will sluggish, and foreign direct investment will be dramatically cut back. The implications will vary by country but in the end it will mean less export revenue and less income as well as a slow down of investment, particularly if it is foreign finance. One can hope that aid levels can be maintained and that by 2010 economic growth will resume. In the meantime, governments need to do their utmost to protect the most vulnerable.

There is no doubt that with the global downturn the risks of protectionism have risen. Fortunately, at least at the G20 meeting of November 15, world leaders urged an avoidance of protectionism during these difficult times and a restart of the Doha negotiations. Of course, the issue of outsourcing of jobs existed before countries turned into recession, but clearly domestic pressures will continue. This said, free trade still offers the best global opportunity to increase incomes and welfare overall. It is the job of government to shelter those who may be the losers in globalization, recognizing that the global gains are usually significant and positive. It is easy to blame globalization for all economic dislocations, even those caused by changes in technology, consumer demand, or educational requirements. Resorting to protectionism will not solve any of these issues and will be particularly deleterious for developing countries where the bulk of the world’s poor reside.

You’re quite right that decoupling is not an option in the current world of increased globalization. Moreover, it is hard to anticipate a crisis the severity of which is largely unparalleled in the post-war period. Nevertheless, vigilant financial supervision of domestic financial entities makes a lot of sense and overreliance on foreign capital, particularly short term capital, may also prove risky for developing countries. While absolute protection or immunity from global recession is not possible, one should of course diversify one’s exports both by sector and market, and try to avoid excessive indebtedness, which can prove problematic in crises such as the one we’re currently experiencing. Strong macroeconomic management has served a number of countries well in this current crisis, the effects of which many are experiencing despite their innocence with respect to the origin of the crisis. Ministers of finance who have been prudent in their stewardship of the economy will find that they have some room for fiscal maneuver during the downturn and central bank governors that have kept a tight rein on financial entities' indebtedness will also see their efforts rewarded.

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The origin of the crisis was in the U.S., where lenders in the housing market took excessive risks. Housing bubbles are not uncommon; however, this particular drop in housing values caused many asset-backed securities to lose their value. This had a cascading effect in financial markets. So in a nutshell, the crisis originated from excessive risk that was not properly overseen by regulators in part because financial markets have gotten extremely interconnected and sophisticated so that it is hard to know who is actually bearing the ultimate risk. This points to the need for global financial regulatory reform.

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Interestingly, China has been one of the main global drivers of economic growth. In fact, the outlook for 2009 would be much bleaker were it not for China’s expected growth of 6-7 percent. China has reduced its projection for 2009 based on recognition that its exports will suffer in light of the recession in many OECD countries. For this reason, China announced a stimulus package for 2009-10 of 7 percent of GDP, which is huge, in order to substitute domestic demand for foreign demand. China will therefore be building more houses, more roads and be adding to its infrastructure, particularly in rural areas, as a way to maintain growth rates which are sufficient to keep the Chinese population employed. This fiscal stimulus will help China, but also will help the rest of the world.

Question answered in English, Spanish translation available soon. A lot will depend on the impact of the recession in the OECD countries on large emerging market economies. In the case of South America, for example, if Brazil manages to keep its growth rate reasonably high, smaller countries in the region who trade with Brazil may not suffer as much as those that are dependent on their exports on the growth rate of the US or Europe. That said, however, we can expect the global turndown to affect everyone to a larger or smaller extent since 2009 will be a year of very weak global growth.

The challenge to poorer or smaller countries is to make sure their fiscal expenditures adequately protect the most vulnerable populations and also that their financial sectors are sufficiently strong so that they are not caught in the big current currently affecting developed financial markets. This requires strong regulatory oversight of the banking system.

For oil exporting countries the great volatility in oil prices is currently a problem. In addition, one should recognize the impact of OPEC price policies for global economic prospects as well. Most responsible oil exporters will base their economic plans and expenditures on the long-run price of oil, not on the highly volatile spot market, and as most of them also have very high levels of international reserves, they will be able to cushion short term revenue reduction.

For non-oil countries in the region, their challenges are similar to other developing countries, namely they have to adjust to slower world growth and smaller inflows of capital. In the Middle East, this is complicated by potential reduction in the flow of remittances and potentially lower employment prospects in the rest of the world. We can expect 2009 to be a difficult year for many of these reasons.

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There is no doubt that this recent crisis shows some of the excesses of unbridled capitalism as described by Professor Stiglitz in many of his books. The answer, however, in my view is not to dismantle capitalism, which has led to the most rapid economic advancements in economic history, but rather, a reform of the regulatory systems, particularly in financial markets, that allow excessive risk taking to occur.

I do not know enough about Islamic banks to comment on their portfolio strategy or risk taking; however, I do know that significant reforms in Western financial markets are required and as the G20 meeting in Washington last week indicated, this seems to be a commonly held view of many nations, including Saudi Arabia, which is a member of G20.

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Clearly the crisis has revealed serious cracks in the financial sector and weaknesses in regulation and supervision. Whereas the Bretton Woods institutions are often looked to for advice and financing in the developing world, at times the developed world has been less receptive to warning signs. To be fair to the IMF, they pointed out the structural imbalances in many of the world’s major economies in recent years.

Nevertheless, as the G20 leaders indicated in their communiqué last week, serious reforms to the world’s financial regulatory regime are long overdue and some of these may involve mandates of institutions created after World War II. One of the reforms already begun at the BWI is to increase the voice and participation of emerging market economies in decision-making as a reflection of their increasing economic importance in the world.

One should not lose sight of basic human needs and the international community has reinforced the importance of economic and social indicators such as those proposed by Paul Streeten and the current terminology for BHNs are the Millennium Development Goals to which the entire international community has committed itself. To achieve the MDGs, however, it turns out that high and sustained levels of growth are indispensible. This was the finding of the recent independent Growth Commission report—led by Professor Michael Spence, whose website is www.growthcommission.org.

Certain interventions are the responsibility of government and are independent of individual earnings. These include the need and right to basic education. Other economic advancements, however, to generate higher levels of income do require job creation. The evidence is that exports and economic growth are the best drivers to increase incomes. A quick look at the history of Vietnam over the last 15 years illustrates this fact dramatically, as income have increased five fold and poverty rates have fallen from 60% to 20%. This is not trickle down, this is economic development and Vietnam has the indicators to back it up.

Question answered in English, French translation available soon. Financial crises tend to revolve around the lack of confidence in financial markets which can include banks and other financial entities. What makes the current financial crisis different from most is that it is affecting financial markets all over the world at the same time. The net result is that stock markets have lost value, holders of particular assets like mortgage-backed securities have suffered big losses, and the insurers of many of these new financial instruments have also gone under in a number of countries. This kind of global meltdown has not really been seen in the last 80 years.