Professional Documents
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Outreach
P U T T I N G K N O W L E D G E T O W O R K F O R D E V E L O P M E N T D E C E M B E R 2 0 0 9
EDITORIAL BOARD
very crisis has its lessons. A global financial and SWAMINATHAN S. AIYAR
MICHAEL COHEN
NEW SCHOOL UNIVERSITY, NEW YORK, USA
PAUL COLLIER
Crisis” as the theme for this issue of Development OXFORD UNIVERSITY, OXFORD, UK
Outreach. JOHN GAGE
As 2009 draws to a close, policymakers in all coun- SUN MICROSYSTEMS, PALO ALTO, CALIFORNIA, USA
tries are assessing the fault lines in their economic man- JOSEPH K. INGRAM
PERUGIA, ITALY
agement systems, and working together in international
KWAME KARIKARI
forums such as the G-20 and IMF/World Bank meetings, SCHOOL OF JOURNALISM AND COMMUNICATIONS,
THE UNIVERSITY OF GHANA, LEGON, GHANA
among others, to define an agenda for reform, and to
improve international coordination systems. VIRA NANIVSKA
NATIONAL ACADEMY OF PUBLIC ADMINISTRATION,
We asked some of the world’s leading economic KIEV, UKRAINE
The IMF has also tripled its lending to $750 billion. Both PHOTO CREDITS
institutions must seek additional support to cover these Unless otherwise noted, all images from Newscom.
Cover: Naylor Design, Inc., Washington, DC; Page 4: Richard B.
new demands, and both face pressure to reform their Levine/Newscom; Page 8: Newscom; Page 12: AFP Photo/Kirill
governance and representation to reflect shifting global Kudryavtsev; Page 13: John Dooley/Sipa Press; Page 16: AFP
Photo/Romeo Gacad; Page 18: AFP Photo/Mauricio Lima;
economic influences. Page 19: AFP Photo/Andrei Smirnov; Page 20: AFP Photo/ Attila
The World Bank Institute, whose mission includes Kisbenedek; Page 22: AFP Photo/Rajesh Jantilal; Page 25:
Benedicte Desrus / Sipa Press; Page 28: Benedicte Desrus / Sipa
capacity building for government officials and other Press; Page 29: Newscom; Page 32: AFP Photo/Joseph Agcaoili;
stakeholders, responded to the economic and financial Page 34: John Dooley/Sipa Press; Page 37: Topshots AFP Photo/Liu
crisis by hosting videoconference discussions among Jin; Page 38: AFP Photo/Roslan Rahman; Page 39: AFP
Photo/Mandel Ngan; Page 41: Newscom; Page 43: Sipa Press;
policymakers in developing countries’ finance, planning Page 45: AFP Photo / Bob Low; Page 47: Newscom; Page 50: Rod
and trade ministries, as well as central banks. Rolle/Sipa Press; Page 53: Richard B. Levine/Newscom.
A series of seminars, Pathways to Development, will fol-
low, aimed at drawing further lessons to help countries
grow out of crisis. This magazine is printed on recycled paper, with soy-based inks.
For his guest editing of this issue of Development ISSN 1020-797X © 2009 The World Bank Institute
Outreach, I would like to thank Raj Nallari, Lead WORLD BANK INSTITUTE
Economist with WBI’s Growth and Crisis Unit. L E A R N I N G F O R D E V E L O P M E N T
Outreach
VOLUME ELEVEN, NUMBER THREE DECEMBER 2009
D E C E M B E R 2 0 0 9 3
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period of deep recession, and several emerging markets were bled industries (for example, General Motors and Chrysler in
sputtering in late 2008. Growth in emerging and developing the U.S. and the French auto industry). Fifth, the govern-
economies has decelerated abruptly to 3.25 percent, mostly ments became “market makers.” However, despite this
because of external pressures—lower foreign demand, reversal expansionary fiscal policy, John Taylor’s article details why the
of capital inflows, and plunging commodity prices. Anemic U.S. and European governments’ fiscal (and monetary) poli-
global growth has reversed the commodity price boom and cies may not work and could actually exacerbate the problem,
lowered inflation. These price declines (except for gold) have including prolonging the recession.
dampened growth prospects for a number of commodity- As a result, public finances have deteriorated in a number of
exporting economies. advanced and developing countries, and this has increased fis-
In the first few months of the global crisis, there were mas- cal risks and raised premiums for government-issued bonds.
sive lay-offs of workers in China’s garment, toy and electronics Early IMF estimates for advanced economies are that fiscal
manufacturing sectors, in Bangladesh’s jute mills, in balances could decline by about 8 percent of GDP between the
Cambodia’s garments industry, and in India’s diamond pol- end of 2007 and the end of 2009, and by 5 percent of GDP in
ishing, textile and garment firms. Martin Ravallion’s article in the case of emerging economies. There is likely to be a dramat-
this issue describes how more than 50 million people may have ic increase in public debt levels in both advanced and develop-
been pushed below the poverty line during the first few months ing economies. Carmen Reinhart’s paper, in this issue, is
of the crisis. If the Asian crisis is any indication, poverty levels based on an historical analysis which concludes that this crisis
are likely to be much higher in several of the affected countries is essentially no different from past crises and that they always
and to remain so, long after the global economy recovers. end with deficit, debt, and default. But small open economies
Professor Sinn’s essay makes an interesting point: that the such as the Caribbean and Pacific Islands are highly dependent
U.S. was the main shock producer because it reduced its imports on external economic conditions and on imports. As Dwight
more than its exports during late 2008 and early 2009. To a Venner’s piece argues, these countries cannot use fiscal stimu-
lesser extent, China, Brazil, the United Kingdom, and South lus packages to respond to an external shock since their
Korea followed a similar practice. In contrast, Germany, Japan increased spending will fully leak out through higher imports.
and Russia were the main shock absorbers as their imports To date, few countries have taken major steps toward trade
exceeded exports during the same period. protectionism, despite the fact that exports fell by as much as 23
percent in China and other emerging markets. However, some
How did policy makers react to the have targeted export firms for subsidies and included protec-
tionist measures in their fiscal stimulus packages. Anne
global economic crisis? Krueger’s essay makes a strong case for open trade policies,
since resumption of global trade is imperative for economic
early on that the current
P O L I C Y M A K E R S U N D E R S TO O D recovery. She argues that with the liquidity crunch, internation-
global downturn was far from your normal garden-variety al traders needed more secured means of payment and there is
recession. The central banks were the first to react, while a demand for newer trade-finance instruments than the tradi-
commercial banks were sharply curtailing credit in the face of tional letters of credit. Moreover, countries have refrained from
global deleveraging—there was monetary easing as interest “beggar-thy-neighbor” competitive exchange rate devaluations
rates were cut dramatically, liquidity provision was stepped to ensure their own exports. Brian Kahn’s essay details the pol-
up, limits to deposit insurance were expanded, and special icy mix that was used to stabilize the South African economy.
credit lines were set up for use by troubled banks. Joseph Stiglitz’s essay focuses on international coordina-
The size of governments expanded overnight. First, sever- tion issues. This is a global crisis and therefore there is a need
al crisis-affected and crisis-prone countries directly support- for collective action, such as the attempts made by the G-20
ed their financial sectors by injecting funds to recapitalize since November 2008. Fiscal stimulus in the U.S. will not be
banks, insurance companies and investment banks, especial- very effective if the Euro zone countries do not stimulate their
ly those deemed “too big to fail.” For example, the economies. When all countries act in concert, the amount of
International Monetary Fund (IMF) estimates that advanced global fiscal stimulus needed is much less, and the world
G-20 economies spent about 3.5 percent of their GDP on such economy will recover much sooner.
financial support. Hungary, Poland, and Ukraine took similar
steps in providing direct support to the financial sector. What is the outlook for the world
Second, as growth slowed in almost all countries, declines in economy after one year of meltdown?
the price of equities, properties, and commodities led to
reductions in government revenues and private and public 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”
spending. Aggregate demand had to be shored up by fiscal in the U.S. and a few other advanced economies between July and
stimulus packages. Third, the losses on funded pension September 2009, but unemployment is still rising in the
schemes increased governments’ fiscal liabilities. For exam- Western world. After increasing between 2000 and 2007, world
ple, countries in the Eastern and Central Asian region have output growth slowed down to about 3 percent in 2008 and is
automatic stabilizers such as unemployment benefits. Fourth, projected to decline by 1 percent in 2009. Underlying these
several countries used public resources to bail out their trou- averages is the fact that advanced economies, which grew at
D E C E M B E R 2 0 0 9 7
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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)
Austria, 2008
Hungary, 2008
US, 1929
UK, 2007
ONGOING Iceland, 2007
Malaysia, 1997
Thailand, 1997
Korea, 1997
Ireland, 2007
Norway, 1899
Argentina, 2001
US, 2007
Sweden, 1991
Spain, 1977
-35.5 percent Historical Average 6 years
Japan, 1992
Norway, 1987
Indonesia, 1997
Finland, 1991
Colombia, 1998
Philippines, 1997
Hong Kong, 1997
D E C E M B E R 2 0 0 9 9
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
7 percent Historical Average 4.8 years
Sweden, 1991
Spain, 1977
Colombia, 1998
Finland, 1991
US, 1929
0 5 10 15 20 25 0 2 4 6 8 10 12
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
-15.1 Average 5.1 years
Colombia, 1998
Finland, 1991
Japan, 1992
Norway, 1987
Default/restructuring Sweden, 1991
Near-default/bailout
Hong Kong, 1997
Mexico
-35 -30 -25 -20 -15 -10 -5 0 0 5 10 15
D E C E M B E R 2 0 0 9 11
Reinhart and Rogoff (2009b) note, the huge buildups in gov- emerging market sovereign defaults since World War II took
ernment debt are driven mainly by sharp falloffs in tax rev- place at levels of debt below 60 percent and would have satis-
enue. The much publicized bank bailout costs are typically fied the Maastricht criteria.6 Debt intolerance applies to both
second order. Fiscal stimulus also adds to the deficits in external and domestic debt.
advanced and emerging market economies.4
Carmen M. Reinhart is Professor of Economics at the University of
Maryland.
Downgrades
(sometimes default) References
Ilzetzki, Ethan, Enrique Mendoza and Carlos Vegh, “How big (small) are
A S S H OW N I N F I G U R E 4
(on the previous page), sovereign fiscal multipliers?” Mimeograph, University of Maryland. College Park, June
default, debt restructuring, or near defaults (prevented by 2009.
international bailout packages) have been a part of the finan- Reinhart, Carmen M. and Kenneth S. Rogoff , “The Aftermath of Financial
cial crisis experience in many emerging markets, therefore a Crises,” American Economic Review, Vol. 99 No. 2, May 2009a, 466-472.
decline in the country rating hardly comes as a surprise. Reinhart, Carmen M. and Kenneth S. Rogoff , “Banking Crises: An Equal
Advanced economies, however, do not go unscathed Finland’s Opportunity Menace,” NBER Working Paper 14587, December 2008. CEPR
Working Paper 7131, January 2009b.
score went from 79 to 69 in the space of three years, placing it
close to the scores for some of the emerging markets! Reinhart, Carmen M., Kenneth S. Rogoff and Miguel A. Savastano, “Debt
Intolerance,” Brookings Papers on Economic Activity, Vol.1 Spring 2003,
1-74
Conclusions and implications for Endnotes
emerging economies 1 “The Aftermath of Financial Crises,” (with Kenneth S. Rogoff), American
A N E XA M I N AT I O N of the aftermath of severe financial crises Economic Review, forthcoming, May 2009.
http://terpconnect.umd.edu/~creinhar/Papers.html
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
government debt. The crises adversely impact sovereign cred- 4 While, historically, stimulus packages have not been as large in emerging
itworthiness, as reflected in higher risk premia. market economies as in advanced economies, fiscal multipliers also appear
The global nature of the present crisis will make it far more to be smaller for the former. Ilzetzki, Mendoza and Vegh (2009) show that
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’ run-
ning large government deficits that are
accompanied by a rapid rise in govern-
ment debt, emerging markets will find
external private financing less avail-
able—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 poli-
cymakers in these countries to remem-
ber 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
Would jumbo loans replace the economic void left by the collapse of the subprime mortgage market?
D E C E M B E R 2 0 0 9 13
debt-equity ratios. The U.S. banking system alone had lost 53 points, the U.S. comes close to the OECD average, and at 3.6
percent of its equity stock by February 2009. points Germany comes close to the Euroland average. Among
The shock waves of the bursting bubble were then mitigated the big European countries, France and Italy lag a bit behind
through extensive bank rescue packages in the order of 4.1 tril- with 3.3 and 2.6 points respectively.
lion euros and Keynesian counter-cyclical budgetary effects in In the winter months some international irritation was
the order of 1.1 trillion euros. The budgetary effects came caused by U.S. officials and scholars accusing Germany of not
through discretionary measures as well as through the built-in providing sufficient Keynesian stimuli against the crisis. The
flexibility of the national tax-expenditure systems. Figure 1 data show that there may have been some foundation for this
shows the changes in the deficit/GDP ratios from 2008 to 2009 allegation. However, the differences are not particularly large.
for the OECD countries and thus measures the respective While it is true, for example, that the U.S. has taken more sub-
countries’ Keynesian stimuli to counteract the world recession. stantial discretionary measures than Germany, the built-in
flexibility of one of the world’s largest welfare states has pro-
Fiscal stimuli vided an automatic stabilization effect that must also be taken
into account. Still, as is shown in Figure 1, the overall U.S. fis-
W H I L E S M A L L E R C O U N T R I E S like Norway, Australia, cal stimulus was somewhat bigger.
Sweden, or Denmark are among the countries that have exert-
ed the proportionally largest fiscal stimuli, the U.K. is the out- Trade balances
performer among the big countries with a 7.3 percentage point
increase in the deficit share in GDP. On average, the OECD H OW E V E R , T H I S I S N AT U R A L since the crisis originated in
countries have increased their deficit share by 4.5 points, and the U.S. and not in Europe. A more important question for an
the euro area has increased its own by 3.7 points. At 4.3 overall assessment of the situation is, therefore, how large the
FIGURE 1: CHANGES IN GOVERNMENT DEFICIT/GDP SHARES 2008-2009, OECD COUNTRIES, PERCENTAGE POINTS
THE BIG SHOCK ABSORBERS on the other hand were Japan, Hans-Werner Sinn holds the Economics and Public Finance Chair at
Russia, and Germany, whose exports all shrank more than the University of Munich and is President of the Ifo Institute for
their imports: by 110 billion, 124 billon and 168 billion dollars 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.
D E C E M B E R 2 0 0 9 15
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D E C E M B E R 2 0 0 9 17
impact of both the crisis and the drought that hit many areas These are the views of the author and need not reflect those of the
of the country this year. Bank, affiliated organizations or member countries.
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 Endnotes
want to participate, and those needing relief during the crisis 1 See Martin Ravallion and Michael Lokshin, “Lasting Impacts of Indonesia’s
will voluntarily leave once recovery is underway. The federal Financial Crisis,” Economic Development and Cultural Change 56(1), 2007,
or state government announces that it is willing to finance up pp. 27-56.
to, say, 15 days of work a month on worthwhile community 2 See Francisco Ferreira and Norbert Schady, “Aggregate Economic Shocks,
projects for any adult at a wage rate no higher than the market Child Schooling and Child Health.” Policy Research Working Paper 4701,
World Bank, Washington DC., 2008.
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 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 devel-
guarantee is credible it will also help reduce the longer-term
oping countries is $2.00 a day; see Martin Ravallion, Shaohua Chen and
costs of risk facing the poor. Thus a well designed and imple- Prem Sangraula, “Dollar a Day Revisited,” World Bank Economic Review.
mented scheme of this sort it can help in fighting chronic 23(2), 2009, pp. 163-184.
poverty as well as transient poverty in a crisis. 4 Shaohua Chen and I have used the latest growth projections for 2009 and
Relief work will need to be supplemented by transfers, in 2010 (as of mid-June 2009) as the “post-crisis” growth rates while the
cash or food, targeted to specific groups of people who either counterfactual (pre-crisis) projections for those done by the Bank in
cannot work due to physical incapacity, including poor nutri- December 2007 for 2009 and 2010. We have used the growth projections
tional status, or should not be taken out of other activities, for private consumption per capita. (Consumption is more appropriate than
GDP for predicting the short-term impacts on poverty, since the shock to
notably school. A recently popular class of transfer programs
GDP is unlikely to be passed on fully to consumption in the short term.)
requires the children of the recipient family to demonstrate See Shaohua Chen and Martin Ravallion, “The Impact of the Global
adequate school attendance, and health care in some ver- Financial Crisis on the World’s Poorest,” for further detail on the assump-
sions. Early influential examples were Bangladesh’s Food-for- tions and methods.
Education Program, Mexico’s PROGRESA program (now called 5 See Jed Friedman and Norbert Shady, “How Many More Infants are Likely
Oportunidades) and Bolsa Escola in Brazil. Such programs aim to Die in Africa as a Result of the Global Financial Crisis?” Policy Research
to strike a balance between reducing current poverty (through Working Paper, World Bank.
the transfers) and reducing future poverty (through the 6 For a fuller discussion of the issues raised in this section see Martin
behavioral responses). In a crisis, the largest benefits from Ravallion, “Bailing out the World’s Poorest,” Challenge 52( 2), 2009,
such programs may well be found in the poorest countries, pp. 55-80.
People attend a job vacancy fair in Moscow. The slogan on the wall reads: "Need work? Come on in, we'll help!"
D E C E M B E R 2 0 0 9 19
which include Turkey). Countries farther to the east, for exam- (though not the income account), while countries to the
ple, Ukraine, Belarus, and in particular Russia are either larg- southeast (FMS) have more pronounced, or very pronounced,
er countries or less integrated with the EU or both. trade deficits. Countries farther to the east are less integrated
Integration has been a mechanism of both propagation and and also depend more on export specialization—they export
mitigation of crisis. Because of the high level of trade integra- mainly oil, gas, metals, and raw materials—and thus have dif-
tion, the crisis has led to a sharp decline in both exports and ferent balance of payments structures reflecting a somewhat
imports. In addition, financial integration is a source of insta- different model of growth and development.
bility, even though their domestic financial sectors may be In the group of countries with current account deficits, the
sound. Thus, countries that are more integrated with the EU lack of demand for their exports and the declining availability
have suffered more from the crisis. On the other hand, these of foreign financing work together to produce sharp and in
countries are also better positioned to profit from the various some cases disastrous recessions. Negative growth rates vary
measures introduced in the EU to support stability and spur between minus almost 20 percent in some of the Baltic coun-
recovery. As long as these measures stimulate trade and stabi- tries to minus 1 percent in some Balkan countries (Poland
lize the financial system that has positive consequences for being an exception with close to 1 percent growth so far this
the more integrated CESE countries because it supports their year). Overall, more open countries (in terms of the exports to
exports to the EU markets. GDP ratio) with trade and income account deficits, such as the
A more fundamental problem of deep integration is that it Baltic countries, are doing worse, while more closed
leads to a strategy of growth that implies high and persistent economies such as Poland, with less of a deficit in their
external imbalances: the main indicator being the current income accounts (for example, the FMS), are experiencing
account deficit. This could be called a neoclassical growth milder recessions. On the other hand, economies that are
model. In the initial phases, foreign investments rush in to more open are better placed to benefit from fiscal and other
profit from high productivity growth in capital scarce measures that are supportive of trade and may also have more
economies and, later on, exports increase sufficiently to cover stable, though not risk-free, financial systems.
the trade deficits: in the process, there is convergence growth,
that is, when growth in less developed countries is faster than Risks and sustainability
in the more developed ones. The real and nominal exchange
rates adjust, basically appreciate, in order to support that E XC H A N G E R AT E R E G I M E S and fiscal policies account for
process. In the end, the remaining current account deficit much of the change in risks and in the assessment of sustain-
reflects the income balance, where the profits and dividends ability of macroeconomic balances. Given that the main vul-
of the foreign investors are recorded. nerability is the external imbalance, the adjustments of the
Countries in transition can be classified by the stage in exchange rates have to be expected, as are the limitations on
which they find themselves in this process. Roughly, EU the activism of fiscal policy, because widening fiscal deficits
member states (NMS) have mostly balanced trade by now 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 distri-
bution 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 finan-
cial and real consequences.
In general, countries with flexi-
ble exchange rates have seen sharp
nominal devaluations, which have
also led to weaker but still signifi-
cant real exchange rate devaluations
(for example, Poland, the Czech
Republic, Hungary, Romania,
Serbia, and Turkey). This has had
some cushioning effect for the trad-
able and the real sectors generally,
In Budapest, Hungary, construction work has slowed down as a consequence of the financial crisis. but in certain cases has increased
financial risks (for example,
D E C E M B E R 2 0 0 9 21
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COSATU (Confederation of South African Trade Unions) members march through the streets of Durban to protest against food, electricity and fuel hikes.
D E C E M B E R 2 0 0 9 23
response. Some of the emerging upside risks included high
nominal and real wage demands and settlements, a turn-
G r ow t h i s D i s a p p e a r i n g
continued from page 21
around in the international oil price, stubbornly high food
price inflation despite a significant decline in agricultural
commodity prices, and high rates of increases in adminis- level of integration and interconnectedness of the financial
tered prices. These factors also contributed to deteriorating system in the EU and in the transition countries would make
inflation expectations. such a crisis even more devastating then the current one. This
The monetary policy stimulus was complemented by a con- is why the International Monetary Fund (IMF) has been called
tracyclical fiscal policy. South Africa was in the fortunate posi- back to support global financial stability—to bail out the banks
tion of having sufficient fiscal space—a result of past prudence in effect. It can be expected that many countries in transition
—to use fiscal policy in a manner that would not raise questions will end up with stand-by agreement before this crisis is over.
about sustainability. It is generally agreed that fiscal stimuli in In addition, the IMF is supporting the so-called Vienna
such circumstances should be reversible, with an emphasis on Initiative, which is a commitment by the banks in countries
increasing growth-enhancing capital expenditure. The prob- that have an IMF program to keep their credit exposure at
lem is that capital expenditure takes time to implement and so existing levels, which should help the process of orderly
may not be well-suited for cyclical purposes. It was therefore deleveraging. However, in the event of mishaps, financial
fortuitous that government had embarked on a large-scale failure would be transmitted through the interconnected
infrastructure expenditure program during the earlier part of banking system quite quickly (Arvai, Driessen, and Otker-
the decade (including road and rail infrastructure, telecom- Robe 2009).
munications, and more recently electricity generation), and The other risk is that these economies may experience
much of this was coming to fruition at a time when most need- stagnation in the medium run. That will have serious conse-
ed from a cyclical perspective. Government and state-owned quences for labor markets. Employment will decline anyway
enterprise expenditure on infrastructure is expected to average and slow growth will accentuate the already existing structur-
9.7 percent of GDP over the next three years compared with 4.5 al imbalances in these markets (high unemployment, signifi-
percent of GDP in 2005/06. The public sector borrowing cant segmentation, low employment), possibly leading to
requirement is now expected to increase to 7.5 percent of GDP social problems and to growing populism. There is little that
in 2009/10 before moderating to 5.3 percent by 2011/12. These the EU can do to address that eventuality, short of engineering
demands on the capital markets are sustainable because gov- a strong recovery with strong import demand, which is not
ernment debt to GDP is currently a modest 22 percent. something that is being forecasted at the moment.
There was also direct stimulus through the budget. The gov-
ernment had budgeted for a surplus of 0.6 percent for the Conclusion
2008/09 fiscal year, and with declining tax receipts the out-
come was a deficit of 1.2 percent. As a result of the slowing in the CESE has
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
economy and a discretionary fiscal stimulus, a deficit of 3.9 been disrupted by the current crisis and it is not certain that it
percent of GDP was budgeted for the 2009/10 fiscal year. It is can be revived in the medium run. In addition, there are still
estimated that about half of this increase was due to lower significant risks that crisis may become even worse, especial-
expected tax receipts, implying an expenditure stimulus of ly if the process of deleveraging does not proceed in an order-
some 2 percent of GDP. More recently the minister of finance ly manner. Switching to the alternative growth model based
noted that tax revenues are likely to be somewhat lower than on higher domestic savings would be difficult and would
anticipated, and a higher deficit outcome is likely. However the depend on the recovery of EU demand for exports from coun-
government has projected deficits for the next two financial tries in transition. If that does not happen either, the return
years to decline to 3.1 and 2.3 percent of GDP respectively. to convergence growth rates may prove problematic in the
South Africa has not been spared from the impact of the medium run.
global crisis. However its policy response should to some
extent help to contain the contraction. Some internal and Vladimir Gligorov is Senior Researcher at The Vienna Institute for
external developments indicate that the worst may be over. International Economic Studies.
Portfolio capital inflows have resumed; the rand has appreci-
ated to almost pre-crisis levels; commodity prices have recov- References
ered from their lows, although still significantly below their Arvai, Zsofia, Karl Driessen, Inci Otker-Robe (2009), “Regional Financial
Interlinkages and Financial Contagion Within Europe,” IMF Working Paper
highs of last year; and most leading indicators show that pos-
WP709/6.
itive growth should be achieved during the latter part of this
European Commission (2009), “Impact of Current Economic and Financial
year. Nevertheless the recovery is likely to be slow and hesi- Crisis on Potential Output,” European Economy, Occasional Papers 49
tant, and dependent to a significant degree on the nature and (June).
speed of the global recovery. Gligorov, V. et al. (2009), “Final Report on Financial Risks in Candidate and
Potential Candidate Countries,” draft paper.
Brian Kahn is Head of Research and Policy Development at the South Gligorov, V., J. Poeschl, S. Richter et al. (2009); “Where Have All the
African Reserve Bank. ‘Shooting Stars’ Gone?,” wiiw Forecast Report 4 (July).
D E C E M B E R 2 0 0 9 25
of development (Pacific) while others are closely connected; fore losing business because of the melt-down of the financial
both conditions have their advantages and disadvantages. sector in the United States and Europe and the prospect of
Some have valuable natural resources such as oil and dia- more restrictions in the future.
monds, while others have little. The situation with the offshore financial sector raises some
Small states suffer from three major handicaps: interesting and important issues for the international com-
■ Diseconomies of scale in production, marketing, distribu- munity, particularly the OECD, in the post crisis era.
tion, and public administration; At present, it would appear that these services are supplied
■ Exposure to high levels of risk because of small populations at competitive prices by many offshore centers located in
and limited physical space; and small economies that have few alternative economic activities.
■ Limited scope and capacity for negotiating with larger If we assume that there are appropriate and effective meas-
states and private sector entities. ures to combat money laundering, tax evasion, and terrorist
financing in all countries and that the demand for such off-
Economic factors shore services is still extremely large—a distinct possibility
given the fact that the movement and trading of financial
toward concentration of eco-
S M A L L S I Z E T E N D S TO L E A D instruments and services across borders far exceeds that of
nomic activities resulting in near monopolies or oligopolies. goods—then this activity constitutes a world market which
Exports are highly concentrated and imports highly diverse, should be accessible to all countries once the necessary regu-
giving them little room for price setting on either front. In latory safeguards are in place.
short, they are price-takers.
Small economies are highly open to external trade, linking How did ECCU respond?
them very closely with the fortunes of the international econ-
omy. The scope for their development therefore lies in two THE EASTERN CARIBBEAN CURRENCY UNION (ECCU)3, with
directions: deeper integration into the global economy, and a population of approximately 600,000, has been severely
concentration on those activities in which they have a relative affected by the crisis directly and by the collateral impact
comparative advantage that, with some effort, could be turned caused by the collapse of a regional insurance conglomerate
into a competitive advantage. because of imprudent investments in the U.S. and the fallout
Those countries that possess neither oil nor diamonds from the Securities and Exchange Commission (SEC) charges
have gravitated toward two activities—tourism and finance. against the Stanford Group of Companies.
These sectors, however, are inextricably linked to the global The scale of the direct impact of the crisis on the ECCU
economy, and have been greatly affected by the crisis. economies can be seen from the decrease in inflows of
There has also been a dramatic decline in foreign direct tourism receipts and foreign direct investment which have
investment in the tourism sector which, in turn, affects activ- accounted for, on average, 28 percent and 23 percent respec-
ity in the construction sector—a major contributor to employ- tively of GDP in the last three years. Travel receipts fell by 2.5
ment. Small states also have large segments of their popula- percent ($80.3 million) in 2008, in contrast to a 3 percent
tion living abroad who contribute to workers’ remittances increase in 2007; while foreign direct investment inflows
which have also been affected by the current crisis. contracted by 29 percent ($1 billion) in contrast to an increase
Empirical studies have indicated high levels of income and of 14.6 percent in 2007. This has had a negative effect on the
output volatility in small economies due to external shocks. central governments’ finances and debt. In particular in 2008
Also noted are the lack of technical skills and institutional the central governments realized a current account surplus of
arrangements to manage such shocks. $77.5 million (0.6 percent of GDP) substantially below that of
The food and energy crisis which immediately preceded $303.2 million (2.5 percent of GDP) in the previous year;
the current crisis had an adverse impact on small states and while their total outstanding debt rose by 2.4 percent to $9.3
lowered their capacity to deal with the current crisis. The fact billion (73.2 percent of GDP).
is that the current crisis is just the latest and most intense of a The ECCU countries, which are united by an integration
number of such events dating back to the demise of the arrangement through the Treaty of Basseterre (1981) and by a
Bretton Woods arrangements in 1971. The period since then common currency and central bank through the Eastern
can aptly be described as the Age of Volatility. Caribbean Central Bank (ECCB) Agreement (1983), have
These financial crises seem to have become more virulent responded at both the country and currency-union levels by
with the passage of time, and have occurred with increasing invoking the provisions embedded in the articles of both
frequency. The Asian crisis, which had a worldwide effect, put treaties.
pressure on the other area to which small economies had The Organization of Eastern Caribbean States (OECS)
gravitated, that is, offshore finance. In an effort to design a Authority and the ECCB Monetary Council, the highest deci-
new financial architecture a whole raft of standards and codes sion-making bodies of both arrangements, have intervened in
was developed, and a particularly stringent approach was both the banking and insurance sectors to take over and
taken to curtailing the activities of offshore financial centers. restructure ailing institutions. They have also accelerated the
The same situation is occurring again as the OECD is now process of implementing a comprehensive regulatory and
focusing its efforts on the offshore sector. This sector is there- supervisory regime to meet the current and future challenges.
Source: ECCB
Source: ECCB
D E C E M B E R 2 0 0 9 27
The ECCU authorities have also developed an Eight Point These first three programs, vigorously executed, are the pre-
Stabilisation and Growth Programme to address the immedi- requisites for approaching the international community to fund
ate global crisis which focuses on: and provide technical assistance for the next three.
■ Financial Programs Public sector investment programs, in the absence of
■ Fiscal Reform domestic fiscal space, would constitute the fiscal stimulus
■ Debt Management required to generate economic activity through quickly acti-
■ Public Sector Investment vated and disbursing projects.
■ Social Safety Net Social safety net programs through transfers and retrain-
■ Financial Sector Safety Net ing are considered important to protect the vulnerable and
■ Amalgamation of Local Banks unemployed.
■ Rationalisation of the Insurance Sector Financial safety net programs require financing to
restructure and recapitalize stressed institutions, and techni-
The role of the international cal assistance to facilitate the development of robust regulato-
community ry and supervisory regimes.
If these three are not adequately supported by external
DISCUSSIONS A R E O N G O I N G with the International sources then the difficulty of successfully executing the first
Monetary Fund (IMF) following Article IV consultations with three will increase significantly.
individual countries, and the IMF Annual Currency Union The amalgamation of local banks is critical to the creation
Review to identify the types of programs that would be appro- of a strong banking sector that is adequately capitalized and
priate in the current circumstances and to work out access to has the capacity to survive in difficult situations. The sector is
Fund resources under the new arrangements following the now overbanked with increased exposure of smaller and
G20 meetings. Most of the countries have already approached weaker banks and high overhead and unit costs.
the Fund under the Exogenous Shock Facility (ESF). The insurance sector is similarly overpopulated with
The financial programs which each country has already agency arrangements that have left the sector highly frag-
formulated would be the platform on which the Fiscal Reform mented and under-regulated.
and Debt Management Programs will be established. These initiatives, emanating from the currency union
The fiscal reform program had started prior to the crisis arrangements and supported by external assistance, should
with recommendations by a Tax Reform and Administration help alleviate the impact of the crisis on these countries.
Commission which resulted in the implementation of value
added taxes, property taxes, and adjustments to personal and Conclusions
business taxes. The current goal would be expenditure reform
and rationalisation of government expenditures to increase THE CONCLUSIONS that can be derived from the experience
the value added for critical sectors. The Caribbean of small states in general, and those of the ECCU in particular,
Development Bank, with its Policy Based Loans and the World are as follows:
Bank with its Development Policy Loans are critical partners ■ Financial stability, given its beneficial global effects, should
in the Fiscal Reform Program. be considered an international public good. Efforts should
Debt management is being given high priority as most be redoubled to ensure that meaningful reforms take place.
countries have extremely high debt to GDP ratios, which have ■ The international community, through the IMF and the
severely limited the fiscal space to respond to the crisis. The World Bank, should develop financial and social safety nets
Canadian government, the IMF, and the World Bank are sup- in consultation with the small states to address their par-
porting the ECCU member countries in taking a structured ticular problems.
approach to effective debt management. ■ Small states should use the crisis to experiment with fun-
damental and creative fiscal and monetary policies to mit-
igate 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.
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.
2 See Table 1
The boardwalk of Belize City, the nation's principal port and its financial
and industrial hub. 3 See Table 2
More than 200 enterprise managers signed a billboard that promises: "No job cuts. No salary cuts. Tide over difficulties," in Hangzhou City, China.
D E C E M B E R 2 0 0 9 29
The global economic crisis 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 ori-
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 of the off-balance sheet assets pushed many financial insti-
gins of the global financial crisis: lax macroeconomic policies, tutions into insolvency. Even worse, the financial innova-
in a context of weak prudential and regulatory oversight, led to tions of the past decade—many of which had been sold on the
excessive leverage, mispricing of risk, and the build-up of promise that they would diversify and minimize risk—turned
global systemic risk. The global financial crisis exposed a num- out to be the transmission mechanism for instability. The
ber of previously known, documented, but unresolved fragili- (relatively small) subprime mortgage crisis thus became a
ties within the increasingly integrated financial system. The full-fledged global financial crisis.
crisis also revealed that surveillance of macroeconomic and ■ The pre-crisis global build-up of capacity in the real econ-
financial sector policies must be even-handed for all coun- omy, specifically in the housing and manufacturing sec-
tries, developed and emerging markets alike. While emerging tors, will result in excess capacity even after the global
markets, having learned lessons from the crises of the 1990s, economy starts recovering. As households respond to the
were closely monitored both by markets and international sudden loss of wealth, by reducing consumption, and the
financial institutions (IFIs), their capacity to influence macro deleveraging of the financial sector reduces the funds
and regulatory policies in mature economies has proven to be available for investment, aggregate demand will decline.
limited. This has been particularly true in large economies The capacity utilization rate of the manufacturing sector
issuing a global currency which experienced little incentive to was 69.1 percent in the U.S. in March, 2009, the lowest
adjust domestic imbalances since external financing needs since statistics began to be collected in 1967. In Germany it
were matched by the excess savings attracted by the depth and was 72 percent and in Japan 65 percent—all record lows for
liquidity of U.S.-denominated asset markets. The global econ- recent decades. Once excess capacity appears, the economy
omy benefited from the strong 2003–2007 business cycle gets trapped in a vicious cycle, it becomes hard for firms to
which was clearly unsustainable. The losses precipitated by the find viable investment opportunities, investment demand
financial crisis have been enormous. Total capitalization of declines, and some firms are forced into bankruptcy. This,
world stock markets was almost halved in 2008, representing a in turn, threatens the income and job security of workers,
loss of nearly $30 trillion of wealth. So far in 2009, markets who then try to reduce spending, and so on.
have recovered about $2 trillion. In the United States alone, the ■ Finally, small, open developing economies typically use cur-
wealth loss for households related to the fall in home prices was rency depreciation and the resulting export-driven growth
roughly $4 trillion by the end of 2008. to come out of a crisis. However, this is impossible in a glob-
Losses of this magnitude have significant wealth effects on ally depressed environment. Policy instruments in both
consumption and savings. Indeed, the current global crisis is developed and developing countries are likely to be less
not limited to the financial sector and is now affecting real effective without coordination. And unless we deal with the
economic sectors. Industrial production in the first quarter of excess capacity, we will all experience a protracted crisis.
2009 fell 23 percent in Eastern Europe, 62 percent in Japan,
and 42 percent in Germany, at seasonally adjusted, annualized Beginning in mid-March 2009 amid signs of a recovery in
rates (SAAR). Globally, industrial production declined by 28 the United States, and confidence that no further major
percent in the first quarter following a 22 percent fall in the financial sector collapses were in the works, markets began to
final quarter of 2008, before easing to a pace of contraction of strengthen and capital flows to developing countries picked
19 percent in April (on a rolling quarterly, SAAR basis). up. Equity flows to developing countries in the first two
During the first quarter of 2009, for East Asian economies, months of the second quarter exceeded the total for the first
such as China and Japan, exports declined by 50 percent or quarter, while bank lending and bond issuance both acceler-
more, and 43 percent in Korea. This year we will encounter ated. Partly as a result, returns on emerging market assets
the largest trade contraction since 1929. surged. Since mid-March developing country markets are up
Commentators, papers, and reports3 have compared the 33 percent as compared with only 19 percent for high-income
nature and intensity of the present global recession with past countries. Nevertheless, markets remain well below pre-cri-
episodes such as the Great Depression of the 1930s and the sis highs. Equity markets, often considered an early indicator
Japanese Recession of the 1990s: of recovery, are pointing firmly to a pick-up, especially in the
United States5 and in a number of developing East Asian
■ Like the Great Depression, the current crisis originated economies. These developments are consistent with a turning
from the U.S. financial system. The size and interconnec- point in the crisis. The prognosis for Europe and Japan, how-
tivity of the U.S. economy facilitated the contagion of the ever, is less upbeat. Although surveys show that consumer and
crisis, following the bankruptcy of Lehman Brothers.4 business confidence are improving, economic statistics con-
■ Unlike the bank runs of the 1930s, this financial crisis tinue to deteriorate.
involved complex financial instruments, harder to re-price, Much uncertainty remains. Global output is now expected
and globally disseminated in the balance sheets of a variety to shrink by 2.9 percent in 2009, the first contraction since
of financial institutions. This created new channels for rapid World War II; world trade is likely to contract by 10 percent in
transmission. The boom was bound to turn to bust. And in 2009; and unemployment will soar in industrial countries, as
D E C E M B E R 2 0 0 9 31
tify sound projects, political economy issues, and so forth. mostly exhausted in developed economies, in developing coun-
Hence, while there is uneven room for fiscal maneuvering in tries, by contrast, opportunities for investments that help break
developing countries, the crisis should, nevertheless, be an through bottlenecks to growth tend to abound. Although some
opportunity to identify targeted investment that would fraction of fiscal resources must be injected in developed coun-
increase future productivity and position these countries to be tries that are at the epicenter of the current crisis, the main pol-
more competitive in the aftermath of the crisis. Infrastructure icy objective should be to create demand as quickly and effi-
seems a logical sector in which sound projects could produce ciently as possible. This can be done by channeling investment
high returns and multiplier effects. to where it can be most effectively utilized: by investing in elim-
In 1998, because of the East Asian financial crisis, China inating bottlenecks to growth in the developing world. Lack of
encountered a situation very similar to the current one. The infrastructure in many developing countries, both domestic
Chinese government adopted a fiscal stimulus package in and regional, is the main bottleneck to growth. Increasing
1998–2002 to remove bottlenecks in infrastructure. In 1997 investments in infrastructure can raise the productivity of the
China had only 4,700 kilometers of highway, by 2002 this had private sector, improve the business environment, and gener-
increased more than five times to 25,000 kilometers. The ate high economic returns. This must be supported with
transportation capacity improved greatly as did port facilities increased financing and underpinned by improvements in the
and the electricity grid. With that kind of fiscal stimulus, efficiency and effectiveness of public spending.
China maintained its average annual growth rate at 7.8 per- Policy makers also need to prevent future crises in the
cent. More importantly, after the crisis the growth rate accel- financial sector. We know that this global financial crisis was
erated. Between 1979 and 2002, the average annual growth caused in part by failures of the pre-crisis regulatory and
rate in China was 9.6 percent. And between 2003 and 2008, supervision framework, especially in the G7. After the crisis,
the growth rate actually increased from 9.6 percent to 10.8 many reports and proposals8 are calling for a strengthening of
percent. This growth was made possible by investment target- prudential regulation, a more accurate evaluation of risk, and a
ed to freeing-up bottlenecks, that is, those sectors constrain- tightening of accounting standards. The pre-crisis regulatory
ing growth in the economy. As a result, though government framework allowed distortions in banks’ behavior and the
debt as a percentage of GDP initially rose from about 30 per- financial intermediation process and did not control financial
cent of GDP to 36 percent in 2002 it then declined as growth pro-cyclicality. There were strong incentives to bypass
increased. By 2006-2007, government debt had fallen to 20 required capital regulations by shifting loans off banks’ bal-
percent of GDP. ance sheets. Furthermore, the risk models did not take into
The lesson to take from China’s experience is that, if the account “extreme events” and mispriced risk, and there was lax
return is high enough to generate higher growth, sufficient rev- governance in the financial sector industry, including in its
enues can be generated to pay for the costs of the fiscal stimulus internal, short-term based compensation rules. Looking
itself. That is, the project may be “self sustainable.” Whereas ahead, some of the areas for reform include: changes in com-
opportunities for growth-promoting fiscal stimuli may be pensation schemes in the financial industry with more empha-
sis on evaluating long-term perform-
ance 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); reassess-
ment of the role and oversight of rat-
ing agencies; and better capital
requirements rules (Basel II) that can
smooth business cycle fluctuations by
reducing pro-cyclicality.
The current crisis is the first “syn-
chronized” crisis in almost eight
decades and as a result, dealing with
it is beyond the capability of any sin-
gle 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.
Applicants attend a job fair in the Makati financial district of Manila, Philippines. For example, in the spirit of building
our common global future, developed
who will have tailored their fiscal stimulus well, removed bot- 6 See IMF Staff Position Note, “Fiscal Implications of the Global Economic
tlenecks to growth, and invested adequately in human and and Financial Crisis,” SPN/09/13, June 9, 2009
physical capital within the limits of their fiscal room for 7 There was, so to speak, no “countercyclical policy response” in the 1930s
maneuver, will be naturally better-off and ready to begin a with countries locked into “gold standard” regimes and balanced budget fis-
cal frameworks. Monetary policy was only gradually eased by 1932-33 and
new and more robust growth cycle based on their comparative
financial repair/restructuring started later after some 2-3 years into the crisis.
advantages in the global economy. For the IFIs, helping this By contrast, by the end of 2008, in the current crisis, policy-makers have
process unfold through lending and technical assistance while used almost every conceivable policy tool and more: capital injection, direct
also building global public goods will be a challenging agenda purchase of troubled assets and discretionary lending by treasury, central
for the next few years. bank support with treasury backing, liquidity provision and various other spe-
cial facilities by central banks, Guarantees, upfront government financing,
even sometimes outright nationalization and liquidation of financial institu-
Justin Yifu Lin is Senior Vice President and Chief Economist of the
tions, and so forth.
World Bank.
8 Financial Services Authority-FSA, “The Turner Review, A regulatory
response to the global banking crisis,” (March 2009); Global Financial
Endnotes Stability Report-GFSR, International Capital Markets Department, IMF
(2009); The High Level Group on Financial Supervision in the EU, report,
1 Although there were differences of viewpoints (Bernanke’s savings glut Chairman Jacques de Larosière, EU, Brussels, February 25th, 2009;
and preference for U.S. assets) numerous warnings were expressed by many International Monetary Fund, “Lessons of the Financial Crisis for Future
academics (Obstfelt, Rogoff, Krugman, Roubini, and others.) and IFIs on Regulation of Financial Institutions and Markets and for Liquidity
global imbalances and their possible abrupt unwinding with consequences Management,” Monetary and Capital Markets Department, IMF, February 4,
for exchange rate and asset price stability. The current crisis was preceded 2009; International Center for Monetary and Banking Studies, “The
by six years of boom in the global economy which can be traced to the burst- Fundamental Principles of Financial Regulation,” Markus Brunnermeier,
ing of the Internet bubble in 2001, and the subsequent expansionary mone- Andrew Crockett, Charles Goodhart, Avinash Persaud and Hyun Shin,
tary policy pursued by the United States Federal Reserve Board. This led to preliminary conference draft, January 2009.
D E C E M B E R 2 0 0 9 33
SPECIAL REPORT
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.
D E C E M B E R 2 0 0 9 35
layoffs, aimed at preserving cash and increasing efficiency order to ensure the success of its main line of business: mak-
and productivity, should not be pursued alone and at the ing and selling bread and other edible foods and snacks.
expense of more innovative solutions. In a recent McKinsey & Because of the financial crisis, access to basic services, as well
Company survey more than 50 percent of the respondents said as their quality has deteriorated. Education is one example, since
that innovation is more important to growth now than it was school attendance tends to decline in low-income countries as
before the crisis.9 Long-term global prosperity and stability incomes drop. The potential for partnering with business in
need to be supported by expanding growth, especially among addressing these issues has not been fully tapped. Business can
the low-income segments. play an important role in reducing the number of school drop-
For example, because severe competition with local com- outs by implementing innovative programs. For example, Tetra
panies in India resulted in reduced profit margins at the high- Pack has a program in Nigeria that provides school meals as part
income market segment, Unilever felt pressure to cultivate of its philanthropic corporate social responsibility strategy;
low-income groups. The company has had outstanding suc- while Britannia has a similar program in India which, was ini-
cess in these markets, offering products in single-use packag- tially supported in part by the Global Alliance for Improved
ing (for example, sachets of shampoo and mini-size soaps), Nutrition (GAIN),10 but which is now primarily profit based.
that were affordable to consumers. By extending its distribu- The financial crisis creates unique opportunities for gov-
tion networks to rural towns through travelling sales agents ernment and companies to reassess their strategies and iden-
(on bicycles and even bullock-carts), the company has con- tify innovative solutions, including creative partnerships, to
tinuously increased its market share in countries like India, tackle the new economic reality the world is facing. Those who
Indonesia, and Brazil. react quickly and forcefully will most likely be the rule makers
The multinational cement producer CEMEX learned a sim- and winners in the post-crisis world.
ilar lesson during the last financial crisis in Latin America.
For CEMEX the crisis was an opportunity to reengage with V. Kasturi Rangan is Malcom P. McNair Professor of Marketing and
low-income market segments, and profitably provide housing Co-Chairman, Social Enterprise Initiative, Harvard Business School.
to the poor, while also creating jobs. CEMEX chose to put an Djordjija Petkoski is Lead Specialist, World Bank Institute
interdisciplinary team of its own employees on the ground in
Mexico to better understand the social and home-building Endnotes
practices of low-income communities, using that knowledge 1 “Global Development Finance: Charting a Global Recovery.”
to develop a successful product line of affordable housing just The World Bank. 2009
for the poor. This approach has also been used in several other 2 “Swimming Against the Tide: How Developing Countries are Coping with
Latin America countries and in Egypt. the Global Crisis.” The World Bank. 2009
Growth based on tapping into low-income markets should 3 “Global Development Finance: Charting a Global Recovery.”
aim primarily at wealth creation, including providing access The World Bank. 2009
to jobs, healthcare, education, and vocational training. This 4 “Global Development Finance: Charting a Global Recovery.”
objective should even precede the marketing of consumable The World Bank. 2009
goods and services that help improve the quality of life of the 5 Atish R. Gosh, Marcos Chamon, Christopher Crowe, Jun I. Kim, and
poor. Arguably, businesses that have provided jobs and Jonathan D. Ostry. “Coping with the Crisis: Policy Options for Emerging
income to low-income people have been the most successful. Market Countries.” International Monetary Fund. 2009
They have given people the ability to buy healthcare and edu- 6 “Global Development Finance: Charting a Global Recovery.”
cation for their children, and acquire property to improve The World Bank. 2009
their quality of life. They normally base their business models 7 “Swimming Against the Tide: How Developing Countries are Coping with
on a holistic assessment of how their labor policies and supply the Global Crisis.” The World Bank. 2009
chain relationships can shape their strategy. Nestlé’s Milk 8 “Opportunities in Adversity.” Ernst & Young. 2009.
District Model illustrates this approach. By providing oppor-
Ernst & Young interviewed a large number of managers and owners of com-
tunities for training, education, and a steady income to poor
panies around the world, first in January 2009 and again in June 2009. The
rural farmers in exchange for a consistent milk supply, Nestle main findings include: about 82 % of respondents still having difficulty in
effectively integrated poverty alleviation into a business accessing credit and this is impacting upon their investment strategy; com-
model that was mutually beneficial: the company has been panies are facing heightened concerns over risks while managing their assets,
able to increase its supply of fresh milk and poor communities and over the likelihood of more regulations; companies are using this crisis to
outsource (23%) and use strategic acquisitions (34%); about 32% are dis-
have benefited from job security, improved nutrition, and a
posing off assets to increase cash and liquidity; in January 2009, only 20%
better standard of living. Similarly, Bimbo in Mexico offers its planned for entering new geographic markets but by June 2009, 33% expect
30,000 travelling salespeople the opportunity for continuing to.
education, supplementary health care in addition to the gov- 9 “The crisis—one year on: McKinsey Global Economic Conditions Survey
ernment-supplied plan, and even a cooperative to help them results,” September 2009.
acquire housing material to upgrade their living environment. 10 GAIN has formed a Business Alliance to explore the space between phi-
The company has also attempted to bring microfinance to its lanthropy and strategic private sector interest by developing new business
100,000 small retailers, and acted as an agent for health and models to fortify foods with necessary vitamins and minerals and making it
property insurance. Admittedly all this has been done in available and affordable to the poor.
A tire shop iin Beijing. China lodged a complaint with WTO over tariffs imposed by Washington on its tire products.
D E C E M B E R 2 0 0 9 37
today. Over the same period, quantitative restrictions on kets, and make little effort to learn about best practices in
imports were almost entirely dismantled, and many other other countries.
barriers to trade were reduced or eliminated. While work still Moreover, for most poor countries, where comparative
remains to be done, international trade in the first decade of advantage lies in abundant unskilled labor, an open economy
the 21st century has been freer than at any time in world his- with a realistic exchange rate provides incentives for growth of
tory. It is no accident that increased integration, “globaliza- export industries which can compete in international markets
tion,” in trading ties was accompanied by spectacularly suc- and employ workers. In the process, workers gain skills and, as
cessful economic growth. growth continues, producers can move “up the value added
The world economy was in a virtuous circle: trade liberal- chain.” This strategy has enabled the rapid growth of East
ization spurred economic growth, which in turn, made it eas- Asian and other countries; no country has maintained satisfac-
ier for politicians to take measures for further trade liberal- tory growth through inward-oriented development policies.
ization. The process was facilitated by falling transport and The rapid expansion of trade (and falling transportation
communications costs. and communication costs) has enabled a “chopping up” of the
Of course, a great deal remains to be achieved to improve value added chain as different parts and components are pro-
material well-being even after recovery from this recession. duced in countries where costs are lowest. This integration of
Poverty will still afflict many people, some countries’ living production across national boundaries has resulted in major
standards will have advanced only slowly, and other challenges productivity gains and accelerated growth, but has also made
will also persist. To address these issues, the robust growth any erection of trade barriers far more costly than in the past.
rates that characterized the past sixty years will have to resume. A final advantage is that an open economy greatly reduces
the ability of individual producing interests to influence
Need for further trade liberalization politicians to grant them special favors. The international
market is objective and performance in that market provides
and resuming those
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 feedback to economic policy makers. By contrast, there is lit-
growth rates will both require further liberalization of trade in tle basis on which to evaluate the performance of domestic
goods and services in the international economy and would be monopolists, protected by high tariff barriers or import
retarded, if not prevented, by backsliding. Consider the ben- licensing requirements.
efits and opportunities that liberalized trade provides. For all
countries, liberalized trade creates an economic environment The threat of protectionism
in which there can be more competition than in a closed econ-
omy, and one in which domestic producers are exposed to a double threat. It can
P R O T E C T I O N N OW C O N S T I T U T E S
international best practice. Either of these benefits alone make recovery from the recession slower than it would other-
raises productivity in countries with open trading regimes; wise be. But it can also greatly reduce the growth potential of
imports are as beneficial in this regard as exports. the international economy once recovery has taken hold, and
Monopolists, and even comfortable oligopolists, generally especially harm the low-income countries by eliminating the
produce low-quality items at high cost in their protected mar- 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 meas-
ure 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 propos-
al 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.
D E C E M B E R 2 0 0 9 39
country is spent abroad, some of the value of the stimulus The North has every reason to lead a coordinated global
leaks to other countries, that is, some of the benefits accrue response to help the developing countries. In recent years the
outside the borders. This is why the global multiplier, the ratio developing countries have been part of the world’s engine of
of the increase in global income for each dollar of government economic growth, and it is hard to imagine a robust global
spending, is much higher than the national multiplier. Every recovery in which the developing countries did not play a role.
country focuses on its national multiplier which measures the A recovery in the North that was not matched by one in the
benefits that accrue internally. The result is that, without South could worsen global imbalances, including trade imbal-
coordination, there will be too little stimulus. ances which in turn could give rise to further protectionist
But matters may be even worse. Without coordination, pressures.
countries will try to design their stimulus packages to maxi-
mize the national multiplier, regardless of the adverse effects The G-20’s inadequate response
on the global multiplier. For example, even if a national
investment project had greater long-term benefits, the fact T H E G O O D N E WS I S T H ATthe G-20 has recognized the prob-
that it may require importing many of the critical inputs and lem. The bad news is that it has failed to respond effectively.
thereby diminish the national multiplier might cause the Most of the money provided has been in the form of loans, and
country to choose a domestic road project instead. the primary responsibility for disbursement has been given to
In an attempt to increase domestic multipliers still further, the International Monetary Fund (IMF). Many developing
many countries have engaged in protectionist measures. countries, just emerging from an overhang of debt, are reluc-
Indeed within a few months of the G20 resolving not to engage tant to get back into the debt trap. Moreover, while the IMF
in such measures, 17 of the 20 had done so. Since then, mat- has promised not to impose on “good countries” the counter-
ters have only gotten worse. Such measures are likely not only productive pro-cyclical conditionalities that have marked its
to be counterproductive, since others will take retaliatory lending in the past—and which would undermine the effec-
measures, but many of them also discriminate against devel- tiveness of any assistance—many developing countries won-
oping countries. The “buy America” provision of the U.S. der whether they will qualify. Some of the programs, while less
stimulus package illustrates this point. America included an stringent than those of the past, still seem austere. Besides, in
exception for countries with which it had procurement agree- many developing countries there is strong domestic opposi-
ments—mostly other developed countries. Thus, even though tion to turning to the IMF, regardless of IMF assurances.
the developing countries are innocent victims of the failure of Countries worry about losing their economic sovereignty, and
U.S. regulatory and macroeconomic policies, they are being in in democracies, governments have to pay attention to the
effect targeted for protectionism. Only through coordinated views of their citizens. Past IMF behavior has not earned it a
action can we prevent such self-destructive measures. great deal of affection, and many citizens are suspicious about
claims of reform. As its critics inside and outside the develop-
Developing countries are the worst hit ing countries are wont to point out, the IMF not only did not
take steps to prevent the crisis but it also had pushed those
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 deregulatory, financial, and capital market liberalization poli-
countries are among the innocent victims of this crisis which cies that played such an important role in the creation of the
is negatively affecting even many of those that did a far better crisis and its rapid spread. The result is that many countries
job of macromanagement and regulation than the U.S. are reluctant to turn to the IMF until they have no other
Indeed, those countries that are most closely integrated into choice, while others are engaged in bilateral borrowing in the
the global economy, having followed the advice of the interna- hope that they can “squeak” through. Global coordination of a
tional economic institutions and opened themselves up the much larger assistance program is needed, more in the form
most, have been among the worst hit. Developing countries of grants and disbursed through a variety of mechanisms, as
have been affected by unprecedented decreases in exports, a the UN expert commission urged.
drop in export prices, a decline in remittances, and a decrease In short, without coordination, we are likely to have a
in capital flows—in some cases even a reversal. And they do smaller and, from a global perspective, a much more poorly
not have the resources to protect their families who are losing designed global stimulus, resulting in a more prolonged
their jobs or to save their businesses that are threatened with downturn and slower recovery.
bankruptcy, let alone to provide an effective stimulus. While Agreement on a coordinated stimulus faces several obsta-
in the North, the crisis began in the financial sector and then cles. First, there is the question of enforcement. Under current
moved to the real sector, in the developing countries, the cri- arrangements, compliance rests on good will. This may be espe-
sis began in the real sector and is quickly moving into the cially problematic in presidential democracies, where parlia-
financial, starting a vicious downward spiral. A crisis of this ment or congress may not support the leader’s commitment.
magnitude is certain to generate follow-on effects in the Reaching an agreement may also be constrained by the var-
financial sector. Even banks that did a good job of credit ied circumstances in which different governments and
assessment could not have anticipated a downturn of the mag- economies find themselves. Although the United States boasts
nitude that many countries are experiencing in, say, the of a large stimulus, a significant fraction of Federal Government
export sector. expenditure increases is being offset by expenditure reductions
Hidden protectionism
agreements
M O R E OV E R , I N T E R N AT I O N A L T R A D E
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 barri-
ers have increased. The procedures used to deter-
mine dumping duties are not based on sound eco- Protestors in satanic costumes at the G-20 Meltdown Protests at the Bank of
England, London.
nomic principles and put developing countries in a
D E C E M B E R 2 0 0 9 41
to be some confidence that foreign institutions and financial markets. The systemic consequences of failing to do so are
products imported from abroad will not induce economic already too evident. Until confidence can be restored, there
devastation. This can only be the case if there is coordination will have to be reliance on host country regulation. Financial
in regulatory policy. But not just any kind of coordination will products and dealings originating from under-regulated
do. The world had been moving to a common “deregulatory” countries and even from countries with a problematic history
framework, and this framework bears considerable responsi- (such as the U.S.) which “promise” to be do better in the
bility for the current crisis. future, will have to be carefully supervised.
In the absence of such coordination, there was a risk of a There will be less financial market integration, but this is
race to the bottom. Financial firms told their governments that part of the price we will have to pay for the failure to adequate-
if they didn’t deregulate, they would move elsewhere. ly coordinate regulatory policy in the past.
Governments, worried about the loss of jobs and revenues, While coordination is absolutely essential, success in
gave in. Today, however, many governments are more aware of achieving it may prove difficult. As I wrote in Making
the costs of this race to the bottom. Iceland provides a telling Globalization Work, economic globalization—the integration
example: its citizens, many of whom never benefited from of the economies of the world especially through finance and
their banks’ irresponsible behavior, will be paying the price for trade—has outpaced political globalization. If we are to suc-
decades to come. Some argue that the high cost of America’s ceed in achieving globalization that leads to a more stable and
bank bail-out—with bondholders and in some cases even more prosperous world for all, we will have to manage it bet-
shareholders being protected, as the Obama Administration ter than we have in the past; and that means more and better
has created institutions that are too big to be financially coordination.
resolved—is the international ramification of a collapse. But
ordinary American citizens are paying a high price for a global Joseph E. Stiglitz is University Professor at Columbia University.
financial system from which they benefited little. He served as Chief Economist and Senior Vice President of the World
Moreover, governments with well-regulated financial Bank from 1997-2000. He was awarded the Nobel Memorial Prize in
institutions should rightly be wary of allowing these institu- Economics in 2001. He He was also chair of the Commission of
tions to deal in an unfettered way with institutions from coun- Experts of the President of the UN General Assembly on Reforms of
tries with inadequate regulation. They are aware that the International Monetary and Financial System.
American banks sold toxic products, not just the toxic mort-
gages, but also dangerous derivatives.
There is an obvious need for coordination in the regulato-
ry structures so that one country can trust the products pro-
duced in another. This will require not only good regulations
but effective enforcement. In the United States and else-
where, 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 over-
ly 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
THE RISK IS CLEAR: if countries cannot rely on foreign
financial institutions and the products they produce, there
will be a marked weakening of global financial market inte-
gration. Governments have a responsibility to protect their
citizens and their economies from the dangers of financial
Major newspapers heads after Lehman Brothers filed for bankruptcy and Merrill Lynch was sold to Bank of America on the same day.
D E C E M B E R 2 0 0 9 43
emerging-market central banks. In several cases, limits on the interest rates helped to inflate commodity prices, notably the
sizes of these swaps have been removed, allowing non-U.S. price of oil, helping to fuel the increased Russian, Middle
central banks such as the European Central Bank (ECB) and Eastern, and Latin American external surpluses. This interna-
Swiss National Bank to supply financial markets with poten- tional income transfer that may have put further downward
tially unlimited quantities of dollars.1 Although limited Fed pressure on world interest rates, as during the oil boom of the
swap lines were created under the Bretton Woods system in 1970s, which was prologue to the 1980s debt crisis.
1962 and have existed in some form ever since, the recent Low interest rates and booming commodity prices during
expansion of such facilities represents an unprecedented del- the mid-2000s contributed to a prolonged period of tranquil-
egation of the Fed’s powers to foreign policymakers. That ity for emerging markets. Many began to question the ongoing
development is a tacit admission that older notions of the LLR need for the International Monetary Fund (IMF), as that
role, while suitable for an insular world characterized primari- institution shrank under pressure of reduced lending rev-
ly by national finance, are ill suited to a twenty-first century enues. As is now evident, however, emerging markets were
environment of financial globalization. benefiting from an exceptionally favorable but temporary
constellation of external forces.
The central banks’ interventions Finally, low interest rates had a dramatic effect on real
estate prices. Low interest rates and the availability of cheap
W H AT M OT I VAT E D T hese central-bank policy actions? The foreign finance, interacting with distortions in markets for
fundamental trigger was a by-product of the process of global housing finance, fueled dramatic house-price appreciation.
deleveraging set off by the Lehman collapse: a shortage of hard- Higher levels of housing equity eased households’ liquidity
currency, especially dollar, liquidity in world financial markets. constraints and supported high consumption levels and
In turn, the dollar liquidity shortage—which has temporarily reduced levels of private saving out of GDP. While similar
slowed the dollar’s long-run depreciation trend—has its roots effects were seen in many other countries—there is a high sta-
in the international financial flows of the years 2003-07. tistical correlation over the 2000s between real estate appre-
Over the 2000s the United States has run a series of histor- ciation and current account deficits—the United States was the
ically large annual current-account deficits. Eastern Europe epicenter of the financial innovations and practices that
also ran large deficits (relative to GDP), as did several individ- sparked the collapse of 2007-08. This fact led to one of the
ual countries within the European Union, including Greece, ironies of the financial crisis: although several analysts had
Ireland, Portugal, and Spain. These deficits were naturally worried up until 2007 that a U.S. housing collapse might sig-
offset by surpluses elsewhere. Within the industrialized nal a compression of the U.S. external deficit and a collapse in
world, countries such as Japan, Germany, Norway, Sweden, the dollar’s value, the housing collapse, at several stages of the
and Switzerland had large surpluses. Within the set of emerg- crisis, actually led to an apparent shortage of dollars.
ing and developing economies, Asia (excluding Japan), the
Middle East, and the Commonwealth of Independent States The European banks and the dollar
ran sizable surpluses while the Western Hemisphere and
African countries did the same on a smaller scale. ONE REASON FOR THE DOLLAR SHORTAGE starting in
While the causes of these imbalances remain a topic of August 2007 was European banks’ high propensity to invest in
active debate, a number of factors stand out. First, the 1997-98 U.S. dollar assets over 2003-07. Initially around $4 trillion in
Asian crisis clearly was followed by an enduring rise in saving- 2003, European banks’ U.S. dollar assets exceeded $8 trillion
investment balances throughout Asia. In some cases, countries by the first quarter of 2007.2 These banks drew short-term
maintained undervalued exchange rates and compressed dollar funding from the interbank market, and also borrowed
demand to promote export-led growth, in the process accumu- nondollar currencies, swapping these funds into dollars on a
lating large stocks of liquid international reserves, mainly dol- short-term basis, to hedge their long dollar positions.3
lars. One clear motive for reserve accumulation was to self- European banking flows into the U.S. were invested heavi-
insure against liquidity shocks rather than depend on the ly in AAA-rated tranches of securitized assets such as sub-
International Monetary Fund as in past crises. Whatever the prime mortgage pools. The high credit ratings of these struc-
causes—the details differ from country to country—a conse- tured products reflected low expected loss, but ignored portfo-
quence of the increase in desired Asian surpluses was a down- lio risk. In fact, the assets carried significant systematic risk
ward pressure on world interest rates and price levels. due to the likelihood of default precisely when all global asset
But it takes two to tango, and both policy as well as institu- markets would be melting down simultaneously. In addition
tional responses in the industrialized world led to a significant to expected return, these structured products carried an
magnification of the volume of world financial flows. The col- important collateral benefit. By holding them instead of assets
lapse of the dot-com bubble, followed by the 9/11 attacks, led subject to idiosyncratic risk and therefore with lower credit
the Federal Reserve and other central banks to lower interest ratings, banks were able to reduce required regulatory capital
rates. Japan remained in the grip of a seemingly intractable ratios. The result was regulatory arbitrage on a large scale.4
deflation. Discerning a similar potential in the U.S. economy, European banks’ need to fund their U.S. purchases through
the Fed held interest rates quite low until embarking on a grad- short-term dollar borrowing made them susceptible to any
ual tightening cycle in mid-2004. Low industrial-country reduced availability of dollar liquidity. This is what happened in
D E C E M B E R 2 0 0 9 45
Journal of Economic Perspectives 13 (Fall 1999): 85-104.
At the moment, the International Monetary Fund—itself
McGuire, Patrick and Goetz von Peter. “The US Dollar Shortage in Global
the improbable product of a visionary postwar exercise in
Banking.” BIS Quarterly Review (March 2009): 47-63.
international political cooperation—is the closest thing we
have to an international LLR.7 The IMF has the capacity not Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor. “Financial
Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008.”
only to create outside liquidity, but also to channel inside liq-
American Economic Review Papers and Proceedings 99 (May 2009):
uidity agents with relatively ample liquidity to markets in 480-486.
which liquidity is scarce. IMF quotas represent outside liq-
uidity. When Pakistan borrows dollars from the IMF, for Endnotes
example, the dollars come from an IMF account at the Federal 1 For description and further references, see Obstfeld, Shambaugh,
Reserve. If the IMF borrows dollars from the government of and Taylor (2009).
Japan’s reserves, however, liquidity may simply be reallocat- 2 See Baba, McCauley, and Ramaswamy (2009), p. 66.
ed, not created. In a crisis situation, even such liquidity real- 3 See McGuire and von Peter (2009).
location by the Fund can help stave off economic disaster for 4 See Acharya and Schnabl (2009).
the borrower. A major structural advantage of the IMF is that
5 See Baba, Packer, and Nagano (2008) and Baba, McCauley, and
it can create liquidity in alternative national monies, thereby
Ramaswamy (2009).
meeting potential shortages of nondollar currencies.
6 See McGuire and von Peter (2009), p. 57.
In recent decades the IMF has intervened almost exclu-
sively with emerging and developing countries. It seems like- 7 Ten years ago Fischer (1999) made this case in detail. It is impossible to
ly that for some time, the IMF will continue to focus on the do justice to the arguments pro and con in the space available here.
group of less prosperous countries, with the LLR needs of
richer countries met through ad hoc bilateral or even multi-
lateral arrangements of the type seen recently. It is not incon-
ceivable, however, that the IMF’s role could someday extend,
as in the past, to the richer countries. Indeed, this develop-
ment seems natural in a world where the current emerging
economies are evolving toward eventual economic and politi-
cal 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 impor-
tance and the nontraditional nature of the lender-of-last-
resort 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 impor-
tant player in performing that function.
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, 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.”
D E C E M B E R 2 0 0 9 47
The only serious alternative is the euro. The euro area pos- bank governor made a splash by arguing that the IMF’s Special
sesses the requisite scale, and also has a large government Drawing Rights (SDRs) should replace the dollar as the
debt market. But its various government bonds differ in their world’s reserve currency.
risk, returns, and liquidity. German government bonds have a The obstacles to making this happen are formidable.
reputation for stability, but the market for these bonds lacks Reserves, as noted above, are only attractive if they can be
liquidity since they tend to be held to maturity by institution- used. Making the SDR attractive would thus require develop-
al investors. Italian government bonds are the most important ing markets on which SDR claims can be bought and sold. It
euro area debt securities in value, but are not attractive as would be necessary to build a market on which governments
reserve assets because of the country’s economic problems. could issue SDR bonds at a competitive cost. Banks would have
Nevertheless, as neighboring countries forge deeper links to find it attractive to take SDR deposits and make SDR loans.
with the EU, they are likely to hold more euros. For example, It would be necessary to restructure foreign exchange markets
recognizing the growing importance of European trade and so that traders went through the SDR.
finance, Russia recently increased the weight of the euro in the Making this happen would require significant investments
basket of currencies used to guide its exchange rate policy. As over an extended period. To start with, if China were serious
the euro becomes more important to Russia as a reference cur- about elevating the SDR to reserve-currency status, it should
rency, its central bank will want to hold a larger share of its then take steps to create a liquid market in SDR claims. For
reserves in euro-denominated securities. In its 2008 annual example, it could issue SDR-denominated bonds. This would
report the Central Bank of the Russian Federation confirmed be a much more meaningful step than buying SDR bonds from
that it had reduced the share of dollars in its reserves from 47 the IMF, as it has indicated it will do.
to 41.5 percent between the beginning of 2008 and the begin- Then there is the question of who would be on the demand
ning of 2009 and raised the share of the euro from 42.4 to 47.5 side of the market. Government bonds are held by pension
percent. In June it indicated that it intended to reduce still fur- funds and insurance companies since the maturity of the
ther the share of dollar-denominated assets in its portfolio. bonds matches the maturity of these buyers’ liabilities. If the
This case illustrates that there is likely to be some further dollar depreciated against the euro, a European insurance
reallocation of reserves from dollars to euros by the countries company holding SDR-denominated bonds and euro-
on Europe’s periphery. The euro will become an increasingly denominated liabilities would find itself in deep trouble.
important reserve currency in that part of the world. Whether Potential investors would need markets on which to hedge
it can surpass the dollar globally, given the greenback’s head SDR currency risk—markets that can only be created at a cost.
start and the euro area’s own unfavorable demographics, is Finally, for the SDR to become an attractive form of
another matter. reserves, the IMF would have to be able to issue additional
SDRs in periods of shortage, much as the U.S. Federal Reserve
The China dollar paradox provided dollar swaps to ensure adequate dollar liquidity in
the second half of 2008. In other words, for the SDR to
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 become a true international currency, the IMF would have to
reserve diversification by China is another matter. Informed become more like a global central bank. Again, this is unlike-
guesses put China’s official dollar assets at roughly eight times ly to happen overnight.
Russia’s as of May 2009. Thus reserve diversification by China
would be a very big deal. An international Chinese currency?
It is not surprising that the issue has become a flashpoint
domestically since China’s foreign currency reserves amount for discount-
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
to $2,000 per Chinese resident. That said, Chinese officials are ing the SDR proposal is that China has a preferred alternative:
aware that they are trapped. The prices of treasuries would tank establishing the renminbi as an international currency. If the
if the People’s Bank of China sold them in sufficient quantities renminbi were to be widely used in international transactions,
to significantly alter the currency composition of its reserve China itself would no longer need to hold foreign currencies to
portfolio. To the extent that dollars still comprised a significant smooth its balance of payments. It could simply print more or
portion of its reserves, the People’s Bank would incur costly less of its own currency, as necessary, like the United States.
losses. One is reminded of Keynes’s aphorism: “When you owe But for now the renminbi remains unconvertible.
your bank manager a thousand pounds you are at his mercy. Foreigners can only use it to purchase goods from China. It is
When you owe him a million pounds, he is at your mercy.” used in cross-border trade only with China’s immediate
The sensible strategy in such circumstances would be to neighbors. Brazil and China recently announced the intention
make a series of small adjustments in portfolio proportions, to explore ways of using their own currencies in their bilater-
which is essentially what China’s reserve managers are doing. al trade. But this agreement is mainly useful for advertizing
This is yet another reason why the declining dominance of the Chinese-Brazilian trade. A Brazilian firm will take renminbi
dollar in reserve portfolios is more likely to be gradual than in payment for its exports only to the extent that it imports
sudden. from China—not your typical case.
Finding itself in this bind, China has, not unreasonably, Similarly, China’s recently concluded swap agreements
begun exploring other options. In March 2009 its central with Argentina, Belarus, Hong Kong, Indonesia, South Korea
D E C E M B E R 2 0 0 9 49
SPECIAL REPORT
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 2003-
2005 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.
FIGURE 3: THE TERM AUCTION FACILITY HAD LITTLE IMPACT ON To assess the issue empirically, one can look at the differ-
THE SPREAD ence between interest rates on unsecured and secured inter-
bank 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 unse-
cured-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 alleviat-
ed simply by central bank liquidity tools. Rather it was inher-
ently 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.
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.
Term Auction Facility
Looking at the lower left of Figure 1 you see that on August 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
9th and 10th of 2007 this spread jumped to unusually high lev- Term Auction Facility (TAF) was introduced in December
els. Bringing this spread down was a major objective of mon- 2007. Similar facilities were set up at other central banks. The
etary policy from the start of the crisis. 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
Diagnosing the problem: Liquidity or (on the right scale) along with Libor and OIS spread (on the
counterparty risk? left scale). Clearly, the TAF did not make much difference.
D E C E M B E R 2 0 0 9 51
FIGURE 4: THE REBATES INCREASED INCOME, BUT NOT FIGURE 5: THE SHARP CUT IN INTEREST RATES WAS
CONSUMPTION. (MONTHLY DATA, SEASONALLY ADJUSTED, ANNUAL RATES). ACCOMPANIED BY A RAPID INCREASE IN OIL PRICES THROUGH
THE FIRST YEAR OF THE CRISIS. (LAST OBSERVATION IS JULY 2008)
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 wors-
week 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 respond-
On 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 pack- factors 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 mon-
questioned intensely and the etary policy interventions, how-
public reaction was quite nega- ever 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 pre-
Congress. 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 identi- John 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 cri- and Janice Arthur McCoy Senior
sis. Not until more than a week Fellow at the Hoover Institution.
later did conditions deteriorate.
Moreover, it is plausible that This essay is drawn from John B. Taylor,
Getting Off Track: How Government
events around September 23
Actions Caused, Prolonged, and
actually drove the market, includ- Worsened the Financial Crisis, Hoover
ing the realization by the public Artist Laura Gilbert's "The Bailout Bill." Gilbert created an Press, Stanford, California, 2009.
that the intervention plan had not edition of 5000 copies to give away.
been fully thought through and
D E C E M B E R 2 0 0 9 53
KNOWLEDGE RESOURCES
TOO BIG TO FAIL: The Inside Story THE IDEA OF JUSTICE, by Amartya Sen,
of How Wall Street and Washington Belknap Press of Harvard University Press,
Fought to Save the Financial System— 2009.
and Themselves, by Andrew Ross Sorkin. Social justice: an ideal, forever beyond
Viking Adult, 2009. our grasp; or one of many practical
Andrew Ross Sorkin delivers the first possibilities? At the heart of Sen’s
true behind-the-scenes, moment-by- argument is a respect for reasoned
moment account of how the greatest differences in our understanding of what
financial crisis since the Great a “just society” really is. People of different persuasions
Depression developed into a global tsunami. From inside might each reasonably see a clear and straightforward
the corner office at Lehman Brothers to secret meetings in resolution to questions of justice; and yet, these resolutions
South Korea, and the corridors of Washington, Too Big to would be completely different. In light of this, Sen argues
Fail is the definitive story of the most powerful men and for a comparative perspective on justice that can guide us in
women in finance and politics grappling with success and the choice between alternatives that we inevitably face.
failure, ego and greed, and, ultimately, the fate of the
world’s economy.
THIS TIME IS DIFFERENT:
Eight Centuries of Financial Folly,
GLOBAL DEVELOPMENT FINANCE, by Carmen M.Reinhart and Kenneth S.
The World Bank, 2009. Rogoff. Princeton University Press, 2009.
Global Development Finance—the Throughout history, rich and poor
World Bank's annual report on the countries alike have been lending,
external financing of developing borrowing, crashing, and recovering
countries—provides monitoring and their way through an extraordinary
analysis of development finance, range of financial crises. Each time, the
identifying key emerging trends and experts have claimed that the old rules of valuation no
policy challenges in international longer apply and that the new situation bears little
financial flows that are likely to affect the growth similarity to past disasters —“this time is different.”
prospects of developing countries. Over the past two years, This book proves that premise wrong. Covering sixty-six
the world has seen turmoil in a relatively small segment of countries across five continents, it presents a
the U.S. credit markets morph into a severe global comprehensive look at the varieties of financial crises,
economic and financial crisis. Although aggressive and guides us through eight astonishing centuries of
monetary policy, fiscal stimulus, and guarantee programs government defaults, banking panics, and
to shore up the banking industry have begun to stabilize inflationary spikes.
financial markets and slow the pace of economic
contraction, policy makers face an extended battle to
revive the global economy. MOVING OUT OF POVERTY:
The Promise of Empowerment and
Democracy in India, by Deepa Narayan.
INVESTING WITH CONFIDENCE: Palgrave Macmillan, 2009.
Understanding Political Risk India has experienced accelerating
Management in the 21st Century, edited growth in the last decade, yet why do
by Gero Verheyen, Srilal M. Perera and millions of people remain mired in
Kevin W. Lu. The World Bank, 2009. poverty? This book brings together
Coinciding with the Multilateral the voices of the poor from 300 villages in the Indian
Investment Guarantee Agency's states of Andhra Pradesh, Assam, Uttar Pradesh, and
(MIGA) twentieth anniversary, this West Bengal, during the decade from 1995 to 2005. It
book examines key political risk issues documents the entrepreneurialism of the poor,
including claims and arbitration, perspectives on pricing arguing that responsive local government, when
from the private, public and multilateral providers, as well combined with access to information, market access
as exploring new frontiers in sovereign wealth funds and and collective action, can do much to facilitate poor
Islamic finance. people’s movement out of poverty.
D E C E M B E R 2 0 0 9 55
CALENDAR
Nov 30– Seventh WTO Ministerial Conference 27–31 World Economic Forum Annual Meeting
Dec 2 Geneva, Switzerland Davos-Klosters, Switzerland
www.wto.org www.weforum.org
1–3 Routes out of the Crisis: Strategies for Local 18–20 Migration: A World in Motion. A Multinational
Employment Recovery and Skills Development Conference on Migration and Migration Policy
in Asia University of Maastricht, Maastricht,
Malang (Java), Indonesia Netherlands
www.ilo.org www.appam.org/conferences/international/
maastricht2010/index.asp
7–18 United Nations Climate Change Conference
Copenhagen, Denmark MARCH 2010
http:/en.cop15.dk
19–21 2nd Annual Meeting on the Economics of Risky
11–12 Institute for the Study of Labor, IZA Workshop: Behaviors (AMERB)
Unemployment Insurance and Flexicurity Stone Mountain, Georgia, USA
Bonn, Germany www.iza.org
www.iza.org
APRIL 2010
12–13 2009 International Symposium on
Contemporary Labor Economics 10–11 The Third International Forum on the Rights
Xiamen University, Xiamen, China of Persons with Disabilities
www.wise.xmu.edu.cn/Labor2009 Hilton Hawaiian Village, Honolulu. Hawaii
www.pacrim.hawaii.edu
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