CIGI Task Force on Developing Countries

The Effect of the World Financial

Crisis on Developing Countries:
An Initial Assessment

Marcelo de Paiva Abreu, Manmohan Agarwal,

Sergey Kadochnikov, Mia Mikic, John Whalley, Yu Yongding

Addressing International Governance Challenges

The Centre for International Governance Innovation

About the Task Force

Summary
• The current financial crisis started in developed countries, but
The Centre for International Governance
reduced foreign investment and reduced demand for imports of
Innovation (CIGI) based in Waterloo, On-
commodities and labour-intensive products are having profound
tario, consistent with its mandate to con- effects on developing countries.
tribute to global debate on contemporary
world problems, has formed a task force • Growing protectionism and massive budget deficits in developed
of eminent economists to study and offer countries that threaten to pre-empt much of the world’s savings
solutions for the devastating effects of the will exacerbate problems for developing countries.
current financial crisis on developing and
transition economies. Reminiscent of the • The many developing countries that lack large foreign-exchange
1930s, when most Latin American coun- reserves and have balance-of-payments difficulties will be able to
tries were in default, several countries re- implement expansionary fiscal policies only with augmented assis-
cently have experienced a sharp reduction tance from the World Bank and the International Monetary Fund
of their international trade, a rapid decline and a relaxation of the conditions under which these institutions
in inward investment flows and, in many lend money.
cases, repatriation of prior foreign invest-
ment and a fall in remittances. This first
• Continuing lack of demand in developed countries implies that
developing countries need to enhance trade and finance linkages
statement by the task force briefly out-
among themselves in order to foster economic growth.
lines the nature of the crisis for developing
countries and suggests in general terms a
• The developed world needs to acknowledge the severity of the ef-
strategy for a way forward.
fects of the current financial crisis on developing countries, to resist
new protectionist measures that would further harm their growth
and development, and to maintain and even increase current aid
and investment flows.

A Brief Outline of the Crisis

The origins of the current world financial crisis are now well known.
They lie in the worldwide financial excesses of the past few years and
even decades; the bursting of the housing and oil price bubbles; exces-
sively low interest rate policies; massive trade surpluses in some coun-
tries and trade deficits in others; and savings rates that are too low in
some parts of the global economy and too high elsewhere. The cumu-
lative effect is a financial and liquidity crisis that threatens to become
The opinions expressed in this paper are those of the authors
a global macroeconomic upheaval, with significantly negative world
and do not necessarily reflect the views of The Centre for GDP growth, perhaps for two or three years, sharply increased unem-
International Governance Innovation or its Board of Directors ployment, pressures on public revenues and deflation.
and/or Board of Governors.

Although the crisis originated in the economies of North America and

Europe, its effects are now global, with particularly serious implications
Copyright © 2009, The Centre for International Governance for the economies of the developing countries. Indeed, the nature of
Innovation. This work was carried out with the support of
The Centre for International Governance Innovation (CIGI), the crisis is very different for developed and developing countries, and
Waterloo, Ontario, Canada (www.cigionline.org). This work among the latter there is also a considerable diversity of effects.
is licensed under a Creative Commons Attribution — Non-
commercial — No Derivatives License. To view this license,
visit (www.creativecommons.org/licenses/ by-nc-nd/2.5/). For In developed countries, the crisis stems from a drying up of credit
re-use or distribution, please include this copyright notice.

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 The Effect of the World Financial Crisis on Developing Countries: An Initial Assessment

flows as financial institutions are no longer able to assess the credit-

worthiness of other enterprises, whether financial or nonfinancial. For Marcelo de Paiva Abreu
instance, the inability of some companies to obtain insurance for or-
ders they have placed with suppliers has caused them to curtail or shut Marcelo de Paiva Abreu earned his doc-
down their production and sales activities. This problem has been ag- torate in economics from Cambridge Uni-
gravated by developments on the demand side, with households com- versity. Dr. Abreu is a special expert in in-
pelled to increase their savings to compensate for the fall in the value tegration and trade at the Inter-American
of their financial and real estate assets. Rising fears of unemployment Development Bank in Washington, DC. He
have also led households to curtail consumption. In this sense, the cri- was formerly a professor at the Catholic
sis differs from most of those in the past in that the problem is not a lack University of Rio de Janeiro, where he be-
of demand for credit but a lack of supply of credit.
gan teaching in 1984. He was chair of the
economics department from 1990 to 1997,
For the developing countries, which have become increasingly inte-
and received a National Scientific and
grated into global trade and finance over the past few decades, the
Technological Research Scholarship. Since
crisis is not one of credit but of falling demand in the markets of de-
veloped countries. The financial crisis in the developed countries did 1995, he has written regularly for O Estado
not initially affect developing and transition economies as the crisis did de São Paulo, a major Brazilian newspaper.
not originate within their financial systems. It was even hoped that the
real economy in the developing countries would escape unscathed and
even that growth in developing countries would help to buoy the world
Manmohan Agarwal
economy, as it did in the recession at the beginning of this century. But
when demand fell in developed countries, volumes and prices of ex-
ports from developing countries declined. This initial severe contrac- Manmohan Agarwal is a visiting senior
tion of output and employment in the export industries of developing fellow at CIGI and a former dean of the
and transition countries in turn has spread to other industries in these School of International Studies, Jawaha-
countries, causing economy-wide declines in output and employment. rlal Nehru University, New Delhi, India,
where he taught graduate economics for
The extent of the effects of the global crisis on developing countries many years. He has taught graduate stu-
depends on the importance of exports and capital inflows in their econ- dents in macroeconomics, both open and
omies. In South Asian countries, for example, exports of goods and closed; international trade; investment fi-
services average 22 percent of GDP, while in Latin America and the nance; and development economics.
Caribbean the share is 26 percent, in sub-Saharan Africa 35 percent, in
eastern Europe and central Asia 40 percent and in East Asia almost 50
His research has been mainly in interna-
percent. For the large developing countries, exports as a proportion of
tional and development economics, though
GDP vary from 15 percent in Brazil to 23 percent for India, 28 percent
he has also worked in the area of environ-
for Turkey, 30 percent for South Africa, 31 percent for Indonesia, 32
percent for Mexico, 34 percent for Russia and 40 percent for China. mental economics, and he has published
Exports from both China and South Korea have dropped, and although extensively in these areas. He has exten-
GDP growth remains positive in China, it is sharply negative in South sive experience working in international
Korea. Russia has been severely affected, with industrial output falling organizations such as the International
by more than 10 percent in the last quarter of 2008 and GDP posting Monetary Fund and the World Bank.
a 27 percent year-on-year decline in the first quarter of 2009; Russia’s
financial reserves have also declined substantially. Dr. Agarwal studied at the Delhi School of
Economics and the Massachusetts Insti-
Countries that depend on exports of primary commodities other than tute of Technology.
oil have also been hit hard because of the sharp decline in prices of
export commodities. Prior to the onset of the crisis, the economies of
sub-Saharan Africa had been growing strongly, buoyed by higher com-
modity prices after a prolonged period of stagnation caused, in part, by
terms-of-trade losses. The recent fall in prices now threatens a return
to the conditions through which these countries struggled during the

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The Centre for International Governance Innovation

1980s and 1990s. But even the oil exporters have seen a sharp drop in
Sergey M. Kadochnikov tax revenues, on which these economies depend heavily.

Sergey M. Kadochnikow is a CESifo The increasing integration of world finance also means that the crisis
research network fellow and doctor of is having a serious effect, both directly and indirectly, on investment
sciences in economics. He has held sev- in developing countries. Not only is foreign direct investment (FDI)
eral positions at Ural State University in declining, but foreign financial institutions are withdrawing their in-
Ekaterinburg, Russia, including associate vestments in developing countries’ stock exchanges and repatriating
professor, dean of the school of econom- the proceeds, resulting in sharp declines, often of more than 50 percent,
ics and head of the department of inter- in stock prices and large devaluations, often of more than 25 percent,
national economics. in their currencies. The drop in stock prices further hurts investment
in developing countries; the effect of currency devaluation, however,
depends on the share of imported inputs in production or in the con-
Mia Mikic
sumption basket of workers. Policies in developed countries, because
of their linkage with developing countries, will influence the outcome
Dr. Mia Mikic works in the Trade and In- in the latter and so need to be discussed in studying the policy choices
vestment Division of the UN Economic for the developing countries.
and Social Commission for Asia and the
Pacific in Bankok, Thailand. She received
her PhD in economics from the University
Policy Responses in the Short Term
of Zagreb in 1985. From 2001-2005, she
was a professor of international econom-
As a short-term response to the financial crisis, governments in all the
ics at her alma mater. From 2002-2005, developed countries and in many developing countries have undertak-
she also served as the director of the inter- en measures, including partial public ownership, to shore up their fi-
national economics and business program. nancial systems. To counter the decline in economic activity, they have
also implemented expansionary monetary policy leading to sharp falls
in interest rates charged by central banks, often to very close to zero,
supplemented by expansionary fiscal policy that has led to ballooning
budget deficits. In itself, such a policy response to an economic down-
turn is not unusual; central banks typically attempt to counter falling
demand for credit by reducing interest rates. In crisis situations, how-
ever, the supply of credit dries up because of developments on the li-
ability side of banks’ balance sheets. In the past, this usually happened
when there was a large-scale withdrawal of deposits — a possibility
that deposit insurance has almost eliminated.

Most recent financial crises have occurred in developing countries and

have been caused by the withdrawal of international credit, to which
the International Monetary Fund (IMF) has responded by injecting
money. In the current crisis, however, the problem has arisen in the
developed countries from the liability side of the balance sheets, and
has occurred because financial institutions have been able to borrow
from international capital markets to finance their lending, thus snap-
ping the link between deposits and loans (banks in Iceland provide an
extreme example).

The crisis in the developed countries is likely to be long-lasting. The

traditional instrument of lowering interest rates is likely to work only
after a significant time lag, as it did in Japan in the 1990s. Governments
have been reluctant to take stronger actions to bolster confidence in

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 The Effect of the World Financial Crisis on Developing Countries: An Initial Assessment

the viability of banks. For instance, banks could have been made more
forcefully to increase their capital, or more public capital injected into John Whalley
banks or bad assets transferred to separate entities. The effectiveness
of expansionary fiscal policy could also be enhanced if government John Whalley is a CIGI distinguished fel-
expenditures were coupled with credit guarantees on behalf of those low and a fellow of the Royal Society of
meeting government demands. Direct help to those who are the pri- Canada. The author or coauthor of doz-
mary holders of toxic assets also might be needed to enable them to ens of scholarly articles, he is one of Can-
service their debt. The situation would be helped by an independent ada’s preeminent experts in the field of
evaluation of the balance sheets of financial institutions and perhaps of global economics. His current academic
major companies. positions include professor of economics
and codirector of the Centre for the Study
In developing countries, policy responses to the current financial cri-
of International Economic Relations, De-
sis will depend on each country’s fiscal and balance-of-payments posi-
partment of Economics, University of
tions. Countries such as China, with ample foreign-exchange reserves
Western Ontario; research associate, Na-
and small fiscal deficits, will be able to undertake effective expansion-
ary fiscal policy. India, with ample reserves but large fiscal deficits, has tional Bureau of Economic Research in
relied more on monetary policy, particularly in making more and easier Cambridge, MA; and coordinator, Global
credit available to producers. Russia and other oil exporters, which de- Economy Group, CESifo, University of
pend largely on oil revenues that are now declining, are experiencing a Munich. Dr. Whalley is a former visiting
worsening of their governments’ fiscal position, which limits their abil- fellow at the Peter G. Peterson Institute
ity to undertake expansionary fiscal policy. Still other countries, partic- for International Economics, Washing-
ularly in Africa, that lack large reserves or whose balance-of-payments ton, D.C. He holds a BA in Economics
situation is precarious might not be able to adopt expansionary fiscal from Essex University (1968), and an
policy unless they are assured of financing on easy terms if they end up MA (1970), M.Phil (1971) and a PhD
with balance-of-payments deficits. For such countries, the confidence
(1973) from Yale University.
of their governments to engage in expansionary policies could be in-
creased by expanding the resources of the World Bank and the IMF and
loosening the conditions under which these institutions lend.
Yu Yongding

In the Longer Term Yu Yongding serves the Institute of World

Economics and Politics at the Chinese
This crisis has revealed serious shortcomings in the current system of Academy of Social Sciences as the direc-
supervision and regulation of the international financial system, and tor, a senior fellow and a professor.
clearly some significant changes will need to be made. But there are
more deep-seated causes for the current problems stemming from the
nature of international money and adjustment. In the 1970s, creditwor-
thy developing countries borrowed from international banks, but the
resolution of the resulting debt crisis in the 1980s ground growth to
a halt in many of them. In response, many developing countries be-
came reluctant to borrow from the IMF and borrowed only limited
amounts in international capital markets. In doing so, they built up
their reserves, denominated in US dollars, often by following conserva-
tive monetary and fiscal policies that kept their economic growth rates
low. Now, however, the growth of massive deficits in the United States
and the decline in the relative value of the US dollar, as well as the pos-
sible emergence of the euro and perhaps other currencies as rivals for
the role of an international reserve currency, could create instability in
the international financial system. This could be avoided by agreement
on new rules for international money.

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The Centre for International Governance Innovation

Since demand from developed countries is likely to remain low for

some time and the fiscal needs of their governments are likely to ab-
sorb a substantial part of the world’s savings, developing countries will
have to take some actions on their own to foster economic growth, in-
cluding accelerating the trade and financial linkages growing among
themselves. Some developing countries have high levels of savings that
could be used for investment in those with a scarcity of savings, while
intra-developing country trade could be enhanced by tariff cuts and the
encouragement of preferential trade agreements among them.

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 The Effect of the World Financial Crisis on Developing Countries: An Initial Assessment

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