The Financial Crisis and the Developing World

An Interview With Jomo K.S.

Jomo Kwame Sundaram, better known as Jomo K.S., is the assistant secretary-general on economic development for the UN Department of Economic and Social Affairs. He is a visiting senior research fellow for the Asia Research Institute, National University of Singapore, and professor in the Applied Economics Department, University of Malaya, Kuala Lumpur. He is founder and chair of IDEAs, or International Development Economics Associates. Jomo K.S. would like to thank his colleagues Rob Vos, Pingfan Hong, Richard Kozul-Wright and Alex Izurieta for their contributions to these responses.

Multinational Monitor: The stock markets in developing countries — the “emerging markets” — are tumbling. What are the consequences for regular people in these countries? Does it matter?

Jomo K.S.: So far, stock markets in emerging economies have plunged by about 50 percent on average, some by more than 60 percent (China, Russia, for example) — much more than the average drop of about 30 percent in the rich countries.

It does matter to ordinary people, albeit in different ways. In most emerging markets, not only rich people, but many middle income households own equities. The losses in equity markets will have direct impacts on their income as well as their wealth.

For the poor, who don’t own any stocks, the indirect impact may also be significant: As stock markets plummet, especially in the current turmoil, the solvency of banks and firms depend on how much capital they own. If the value of their capital plunges, even solvent firms will suddenly look overleveraged and face problems.

Banks are now trying to shore up their capital positions, and many have stopped lending. This leads firms to cut their investment spending and use remaining earnings to cover operational costs, which may lead them to start laying off workers.

In the present situation, the drop in stock market prices is part of a downward spiral which will undoubtedly cause the world economy to slow down, causing increased unemployment and worsening work conditions. That will also affect government revenue and further limit the scope for government spending on social services and transfers to the poor.

So, the overall impact will be felt by all, albeit in different ways. Much will depend on how governments respond with counter-cyclical and social protection policies, and following the economic liberalization of recent decades, the latter is unlikely to be a major policy priority.    

MM: Is there a rational explanation for why international financial capital is pulling out from developing countries?

Jomo K.S.: Yes, there are a few explanations. When there is a global financial crisis, international investors (pension funds, mutual funds, and of course, hedge funds) become more risk averse, reducing their exposure to emerging markets, which are considered to be riskier than other investments (such as the U.S. treasury notes).

Some international institutional investors are forced to withdraw by “margin calls” at home: their losses in developed country markets force them to withdraw some of their investments from emerging markets.

More fundamentally, the global financial crisis will seriously weaken growth worldwide, including in emerging markets. As a consequence, earnings in emerging markets will fall, reducing investor interest in emerging market stock.    

MM: In light of the financial crisis, what trends do you expect to see in foreign direct investment (FDI) in developing countries in the next one to two years? What impact will this have on developing country economies?

Jomo K.S.: FDI inflows to emerging markets tend to be more stable than short-term equity investments and other portfolio flows. Nonetheless, the global financial crisis will also affect FDI inflows negatively. With the total supply of funding available in developed countries tightening, financial crisis and global recession will reduce investments, including investments abroad. UNCTAD’s latest World Investment Report expects a 10 percent drop of FDI to emerging markets in 2008 compared to 2007. With the slowdown, FDI will slow further in 2009.

MM: Shrinking economies in the United States and other rich countries seem certain to shrink export opportunities for developing countries. How will this affect them, and how do you suggest they adjust? Are there lessons about relying so heavily on exports to drive economic development?

Jomo K.S.: Fifty percent of U.S. imports are from developing countries. So, shrinking demand in rich countries will have significant impacts on developing countries. In fact, a slowdown in exports of developing countries, particularly in Asia, is likely to lead to a significant slowdown in industrial production, as well as GDP [gross domestic product], in many developing countries. In Latin America and Africa, export growth has mainly been driven by primary commodities.

Various issues of the UN’s World Economic and Social Survey have reiterated the risks of heavy dependence on exports which do not have strong linkages with the domestic economy, particularly primary commodities. Such economies tend to be very vulnerable to external shocks. High commodity prices, responsible for the last half-decade of rapid growth in many developing countries, have already begun to decline in the last half-year, with the price of oil dropping 40 percent in the last three months.

In the short run, developing countries should stimulate domestic demand, so as to offset weakening foreign demand, as China has been doing. For the poorer countries, the scope for doing so is more limited; they may need more foreign aid to cope with the drops in export earnings because of weakening commodity prices and global recession. In the long run, however, they need to engage in active investment and technology policies to diversify their economies and reduce their dependence on a few commodity exports.

MM: What lessons does the financial crisis hold for proponents of financial liberalization in developing countries? Do you think pressures for financial liberalization will abate — and if so, for how long?

Jomo K.S.: Earlier pressures for financial liberalization will likely abate, though it is not clear for how long. Calls for more regulation and government intervention are typical responses during crises, but once the crisis subsides, the pressure to reform may be lost. This crisis — like the financial crises of the 1980s and 1990s, which mainly affected emerging market economies — shows that financial deregulation has gone too far. Quick fixes during a crisis typically do not offer adequate solutions preventing crises from emerging again in the future. For developing countries, at least three things are important.

First, affordable financing should be available for productive long-term investments not disrupted during downturns. Development banks can help ensure long-term, large-scale investments which rely heavily on government resources. Commercial banks should also have incentives to support productive investments. Deeper financial markets, especially bond markets, can also play useful roles in emerging market economies.

Second, financial regulation should be strengthened. Existing approaches to regulation should be appropriate to new conditions and challenges. Now, in most countries, banks have to increase provisioning against bad loans after they encounter problems. Such requirements are pro-cyclical, tightening credit when it is needed most. Regulatory frameworks need to be counter-cyclical, in this case, building capital reserves during good times to provide resilience for bad times.

Third, countries should have appropriate capital controls in place to avoid undesirable and excessive capital inflows when not needed, and to stem sudden, disruptive large outflows.

MM: Do you see contradictions between the massive interventions by the U.S. government (and increasingly other rich country governments) in response to the financial crisis, and the policies recommended and/or mandated by the International Monetary Fund in the 1997-1998 Asian financial crisis and others focused on developing countries?

Jomo K.S.: Yes. It is obvious. Some of the measures the U.S. adopts now were those the U.S. Treasury and the IMF criticized harshly during the Asian crisis — efforts to force banks to lend at low interest rates, bail-outs of banks and other financial institutions, even restrictions on short-selling. I have joked that former Malaysian Prime Minister Mahathir Mohamad is the true American Idol, at least for the U.S. Treasury and Fed today.

Thankfully for the U.S., the Fed has a broader mandate than most other central banks today, which are often required to focus almost exclusively on containing inflation, whereas the Fed is obliged to sustain growth and employment.

MM: Is there a developing country perspective (or perspectives) that are distinct from the general commentaries in rich countries?
Jomo K.S.: Once again, developing countries will have to bear the brunt of the global financial crisis originating in the U.S. and other developed countries. The financial positions of many developing countries are much stronger than they were at the time of the financial crises in Asia and Latin America, given their strong foreign reserve positions and generally better fiscal balances.

Yet, this does not mean these countries are immune to the crisis originating in the developed countries as suggested by those who claim that the larger developing countries have “decoupled” from the U.S. economy.

The financial crisis is likely to lead to a severe and possibly protracted downturn in the global economy which will depress commodity prices and foreign investments once again.

Further, the U.S. dollar is likely to continue to depreciate. The brief resurgence this fall is not likely to last, given the huge U.S. trade and budget deficits. As most reserves of developing countries are held in dollars, those with strong foreign reserve positions will incur massive losses.

Nonetheless, those countries with massive trade surpluses will continue to buy U.S. Treasury notes for various reasons, thus continuing to finance the likely rise in the U.S. fiscal deficit to finance the bailouts as well as fiscal and other counter-cyclical measures.