48389 the special ResearchDigest Financial Issue WorldBank Crisis on Volume 3 l NumbeR 2 l wiNteR 2009 Lessons from World Bank Research on Past Crises C rises have been much studied, poverty--including a lack of connec- In ThIs Issue including at the World Bank. tivity to markets and a consequent lessons from world bank Research on Past Entering financial crisis in the lack of opportunity for economic Crises ... page 1 search engine for the Bank's Policy advancement--will protect the poor Trade-offs between rapid crisis response and Research Working Papers brings from the crisis to some degree. But longer-term development goals mean difficult up more than 650 research papers significant welfare impacts can be choices issued since 1990. Of course, not expected, notably in countries--and all these papers are relevant to a in regions within countries--that FoCuS particular crisis. And others that do have benefited from market-oriented How Should Developing Countries Respond to the Current Crisis? ... page 2 not mention the word crisis may be development. relevant; the literature on famines Poverty is very likely to rise in a Developing countries' mixed record in using fiscal policy to deal with financial crises offers and natural disasters, for example, crisis, though by how much will de- lessons for today contains insights for social protec- pend on the extent of the aggregate tion policy responses to a financial economic contraction and the rise in Financial market Failures: Searching for crisis. The Bank does not have a inequality (if any). An aggregate pov- lessons, Not Scapegoats ... page 3 monopoly on crisis research. None- erty measure cannot tell the whole The main source of financial fragility? A web theless, as the world enters what story, however. There are likely to of contradictory incentives that undermines is clearly a major financial crisis, it be both gainers and losers at every the effectiveness of regulation and supervision is worth taking stock of the lessons level of living, including among the that might be drawn from the Bank's poor. And there may well be adverse bailing out the world's Poorest ... page 4 past research on crises. impacts on important nonincome As the financial crisis spills over to the Arguably, greater openness in dimensions of welfare, including the developing world, what can be done to help such areas as trade and migration nutrition and schooling of children. protect the poorest? helps countries deal with domestic Even a short-lived crisis can have Are All the Sacred Cows Dead? ... page 5 shocks, but may well increase vul- longer-term impacts for some of What are the implications of the crisis for nerability to external shocks. Global- those affected, most notably through the financial and macroeconomic policies ization has probably facilitated con- the nutrition and schooling of chil- underpinning Western capitalist systems? tagion of the 2008 financial crisis, dren in poor families. And deficient though some economies and some crisis responses can plant the seeds beyond Doha ... page 6 people are likely to be more vulner- of longer-term vulnerability to crises. The crisis has brought greater urgency to able than others. The extent to which these adverse trade challenges--and the Doha agenda falls Even an economywide crisis outcomes materialize will depend in far short can have diverse, heterogeneous part on the policies adopted by de- impacts that warn against simple veloping country governments. The the impact of the Financial Crisis on the generalizations and also point to record of past policy responses to Developing world ... page 7 the need for a flexible social policy crises contains both successes and All developing regions are expected to see a response. It should not be presumed failures. slowdown in growth in 2009 that the poorest will be hit hardest; A new paper by the Develop- indeed, some of the same (undesir- ment Research Group reviews les- able) factors that have kept a signifi- sons from the Bank's past research cant share of the developing world's on the causes of past crises and the population in deep and persistent (continued on page 8) 2 WorldBankResearch Digest FOCUS How Should Developing Countries Respond to the Current Crisis? Developing countries considering high inflation, if fiscal deficits are mon- to be effective and can be counterpro- a fiscal response to the financial etized, or a debt crisis, if developing ductive otherwise. In Argentina, for crisis should heed the lessons countries borrow excessively at high example, a mistimed fiscal impulse in of the past sovereign spreads. Only governments 1996­98 spent public resources when a T with strong fiscal positions and large recovery boom was already under way, he prospect of a deep global reserve stocks are well placed to un- undermining the state's room for ma- slump has brought attention to dertake a successful fiscal response to neuver in the crisis that followed. discretionary fiscal policy as a the crisis. · The success of a fiscal expansion de- potential tool for mitigating the se- · Fiscal policy responses to the crisis pends greatly on how it is delivered. In a verity of the slowdown. Developing should be either reversible or likely to yield deflationary environment, increases in countries, however, have a decidedly long-term productivity gains. This is crucial spending on public projects will gener- mixed record in using fiscal policy to to ensure that long-run fiscal and debt ally be more effective at stimulating stabilize fluctuations in output. Insti- sustainability is not jeopardized by aggregate demand than tax cuts or tutional weaknesses, the limited role a countercyclical spending increase. direct transfers to households, which of automatic stabilizers, and limited Projects that act as automatic stabiliz- tend to be saved rather than used for access to financing for expansions ers are one way to achieve this. For ex- consumption. In developing countries have often led to mistimed or inef- ample, workfare programs with below- with large informal sectors there is the fectual fiscal measures in the past. market wage offers will attract par- additional problem that tax cuts and A recent paper by Servén and Kraay ticipants in downturns but will not be social insurance transfers will fail to identifies some key lessons that have appealing once the economy recovers. reach many of the poorest households emerged from these experiences, and Another way of reducing the risk of un- and firms, thereby increasing inequal- suggests that policy makers should sustainable public debt accumulation ity and social tension. Yet public take these into account before initiat- is to increase spending in areas with spending programs can be wasteful, ing a fiscal response. reasonable expectations of long-term captured, and hard to reverse if insti- · Any fiscal response should be com- growth benefits. For example, China's tutions are weak. Fiscal policy should mensurate with the shock experienced. The successful fiscal expansion in response factor in such constraints and choose speed and magnitude of the growth to the East Asian financial crisis of delivery channels tailored to the char- slowdown will differ greatly across de- 1997­98 spent heavily on infrastructure acteristics of the economy. veloping economies, varying with their projects for which there was strong For most developing countries, ex- dependence on trade, foreign invest- local demand. Similarly, spending on pansionary fiscal policy has not been ment, and remittances. Thus each social safety nets is particularly crucial an effective tool for responding to country should first carefully assess in areas in which short-term coping economic downturns in the past. This its expected exposure to the crisis to mechanisms (such as selling assets or does not mean that fiscal policy can avoid an unnecessary or excessive fis- cutting back on caloric intake) can re- play no role in mitigating the effects cal response. duce productivity and well-being in the of the current crisis. Instead, it implies · Monetary policy options should also be long run (through an inability to pro- that countercyclical fiscal measures considered. Policy makers need to coor- duce or through stunting and reduced should take into account the lessons dinate monetary and fiscal interven- cognitive abilities). from past experience to provide suc- tions. In many developing countries · Fiscal expansion must be timely but not cessful short-term relief without un- the central bank's policy interest rates rushed. To minimize the potential for dermining long-term development. are still high and inflation is modest, waste and fraud, policy makers should suggesting that there may be room not rush into new and untried public for traditional easing measures. Yet spending projects. They should first decision makers need to recognize consider expanding existing and well- that relaxing monetary policy also functioning programs and financing entails risks, including downward preappraised and "shovel ready" new pressure on exchange rates and the projects. This is particularly true in de- loss of anti-inflationary credibility in veloping countries in which the capac- countries with a history of monetary ity to appraise and adequately oversee recklessness. untried projects is limited. But while it Luis Servén and Aart Kraay. 2008. "Fiscal Policy · Fiscal expansions need to be sustain- is important to act circumspectly, pol- Responses to the Current Financial Crisis: Issues ably financed. Otherwise, stimulus icy makers should keep in mind that for Developing Countries." World Bank, Develop- measures can backfire and lead to fiscal interventions need to be timely ment Research Group, Washington, DC. WorldBankResearch Digest 3 Financial Market Failures: Searching First, crisis preparedness is impor- tant to avoid short-termism in crisis for Lessons, Not Scapegoats management. Accountability would be greatly improved by requiring that regulators establish and regularly test Good regulatory design requires and what should be done to prevent a well-publicized benchmark plan for attention to incentives similar events. crisis resolution. Second, regulators T A recent paper by Caprio, Demirgüç- need to draw on market signals to he current financial crisis, oc- Kunt, and Kane seeks to make it clear overcome information problems and curring during a period of strong that the main source of financial insta- improve their ability to track risk in world macroeconomic growth bility is not the aberrant behavior of and out of crisis. Requiring the larg- and low interest rates, appears to a few greedy individuals or a sudden est banks to regularly issue a series have surprised financiers and regula- weakening of important institutions of credit default swaps or uninsured tors alike. The turbulence was trig- of a particular country at a particular subordinated debt would provide such gered by a sudden and widespread time. Systemic financial fragility stems signals, since the holders of these loss of confidence in securitization instead from a web of contradictory instruments would apply the market and financial engineering and by the political and bureaucratic incentives discipline that pillar three of Basel II failure of respected statistical models that undermines the effectiveness of seeks to harness. for assessing and pricing credit risk. financial regulation and supervision Third, the safety net needs to be These now-doubtful techniques had in every country. Weaknesses in super- strengthened by making authorities previously been hailed as the corner- visory incentives encourage modern more accountable for its cost. This stones of modern risk management. safety net managers not only to tempt requires developing a system of fair- Moreover, the turbulence proved financial institutions and their cus- value accounting for intangible safety greatest in countries whose supervi- tomers to overleverage themselves in net subsidies, to establish political sion of credit risk had been thought creative ways, but also to close their accountability for controlling them. to be the best in the world. Indeed, own eyes to the unbudgeted costs of Important institutions and their super- these countries' regulatory standards the loss exposures that excess leverage visors must be required to model, es- and protocols were being emulated passes on to financial safety nets until timate, and expose to outside review worldwide. it is too late to control the damage the value of this intangible source of As the crisis unfolded, the world that results. income--at individual institutions witnessed a series of unprecedented These incentive conflicts explain and in the aggregate. Finally, the events, including a previously un- how securitization went wrong, why decision-making horizons of govern- thinkable rate of default on AAA in- credit ratings proved so inaccurate, ment officials could be lengthened if struments, the first run on a U.K. bank and why it is superficial to blame the employment contracts included a de- in 150 years, and an explicit exten- crisis on mark-to-market accounting, ferred compensation fund that heads sion of the U.S. safety net to cover a an unexpected loss of liquidity, or of supervisory authorities would have major insurance company, the entire trends in globalization and deregula- to forfeit if a crisis occurred within a investment banking industry, and two tion in financial markets. couple of years of their leaving office. giant government-sponsored hous- The analysis also finds disturbing The discussion of how best to re- ing finance enterprises (Fannie Mae implications of the crisis for Basel form regulation and supervision of and Freddie Mac). These events were II and its implementation. Since au- financial institutions is likely to con- followed by the demise of a number thorities will be reforming the archi- tinue. But it is important to keep in of commercial and investment banks tecture of financial regulation, how mind that ultimately the goal of finan- and a sharp, worldwide plunge in eq- this reform should proceed and what cial regulation and supervision is not uity stock prices that was especially lessons developing countries ought to reduce financial institutions' risk pronounced for the financial sector. to draw from this crisis are focal is- taking but to manage the safety net so Inquiring minds yearn to know how sues. The paper proposes reforms that that private risk taking is neither taxed this financial crisis could have oc- would improve incentives by increas- nor subsidized. This goal implies that curred in the 21st century and, espe- ing transparency and accountability supervisors have a duty to see that cially, how it could have originated in in government and industry alike. risks can be fully understood and fairly the United States, home to arguably Perhaps most important are the pro- priced by investors. No one should ex- the most sophisticated financial sys- posals for enhancing accountability pect that, in a risky world, risk-neutral tem in the world. Promptly uncovering of government officials, through bet- regulation and supervision can elimi- the true roots of the crisis is impor- ter crisis preparedness, greater use of nate the risk of financial crises; what tant because false explanations are market information to track risks and it can do is to reduce their frequency quick to gain a toehold. Policy makers subsidies, the publicizing of estimates and cost. and pundits often latch onto simplis- of safety net subsidies, and deferred tic theories of what happened, why, compensation schemes. (continued on page 4) 4 WorldBankResearch Digest Bailing Out the World's Poorest A significant share of the poor can care). There is evidence from impact current relief efforts to include nor- be protected in a crisis without evaluations that such conditional mal times at which demand would be damaging longer-term prospects of cash transfer programs bring nonneg- much lower but almost certainly not escaping poverty ligible benefits to poor households-- zero. It would also relax the eligibil- A in terms of both current and future ity restrictions often found on relief s the financial crisis emanat- incomes--through higher investments work. It would rely very little on ad- ing from the U.S. housing and in child schooling and health care. ministrative discretion in access to the financial markets spills over to A common drawback of targeted program (either in turning it on and the developing world in 2008/09, many cash transfer schemes is that they off or in determining who gets help). governments and citizens are asking tend to be relatively unresponsive to As long as the guarantee is credible, what can be done to help protect the changes in the need for assistance. A it would also help reduce the longer- poorest. There is a compelling case previously ineligible household that term costs of risk facing the poor. Thus for believing that the composition of is hit by (say) unemployment of the it can help in fighting chronic poverty public spending and taxation should main breadwinner may not find it easy as well as transient poverty in a crisis. change in favor of the poor. But the to get help from such schemes. While It is possible to protect a significant evidence on past performance is not a temporary increase in the transfer share of the poor in a crisis without encouraging; too often it is spending payments to existing beneficiaries can damaging longer-term prospects of on the nonpoor that is protected. help in a crisis, a temporary expansion escaping poverty. This would prob- If an adequate safety net exists, in coverage will probably also be need- ably require a combination of relief it should of course be supported to ed, and this can be harder to achieve. work with transfers (in cash or food) protect the poor in the crisis. If no One way to ensure that the safety targeted to specific groups that either such safety net exists, a crisis may well net provides effective insurance--a cannot work (because of physical in- create the political space for build- genuine "safety net"--is to build in capacity, including poor nutritional ing one. But crises have given birth design features that encourage only status) or should not be taken out to some of the worst social protec- those in need of help to seek out the of other activities (notably school). tion policies as well as to some of the program and encourage them to drop best. Governments have sometimes out of the program when they no been drawn into introducing general- longer need help because of better Martin Ravallion. 2008. "Bailing Out the World's ized food and fuel subsidies that have options in the rest of the economy. Poorest." Policy Research Working Paper 4763, World Bank, Washington, DC. come at a huge fiscal and economic The classic example of such self- cost and are not easily reversed, yet targeting is a workfare program (vari- have had at best a modest impact ously called relief work or public works (continued from page 3) on poverty. But some developing programs; food-for-work programs countries have been able to turn a also fall under this heading). Workfare Financial Market Failures: crisis into an opportunity for disman- has been widely used in crises and Searching for Lessons, Not tling inefficient subsidies in favor of by countries at all stages of develop- Scapegoats more effective safety net programs. ment. These programs, if well designed The starting point for many de- and implemented, can be responsive Early statements by policy makers veloping countries will be a weak to differences in need--both be- have tended to label the securitization safety net, with limited potential for tween people at a point in time and meltdown as purely a "market failure." protecting the poor from an econo- for a particular person over time. But the market's failures were embed- mywide crisis. There will also be lim- An ideal workfare scheme guaran- ded in a parallel failure in government ited information on the likely profile tees low-wage work on community- supervision. Giving more power to reg- of welfare impacts, though an effort initiated projects. The low wage ulators without first improving their should still be made to anticipate rate ensures that the scheme is self- incentives will not fix anything impor- the types of households and places targeted because the nonpoor will tant. Even in countries whose markets that will be most vulnerable, using rarely want to participate. The federal are unsophisticated, good incentives the best available data and analytic or state government announces that and reliable information can produce tools. Crises have often presented it is willing to finance up to (say) 15 effective regulation. That bad incen- opportunities for setting up better days a month of work on community tives generate misinformation and information systems for monitoring projects for any adult at a wage rate painful losses is the cumulative lesson progress and for future preparedness. no higher than the market wage rate that this and other crises impart. A recently popular class of transfer for unskilled manual labor in a nor- Gerard Caprio, Asli Demirgüç-Kunt, and Edward programs requires the recipient fam- mal year. The work is available to any Kane. 2008. "The 2007 Meltdown in Structured ily to demonstrate adequate school adult at any time, crisis or not. This Securitization: Searching for Lessons, Not Scape- attendance by its children (and, in would extend the coverage of the goats." Policy Research Working Paper 4756, some versions, adequate child health public works schemes often found in World Bank, Washington, DC. WorldBankResearch Digest 5 Are All the Sacred Cows Dead? Policy responses to the financial The paper draws on a large body of price stability and financial stability. crisis have shaken the confidence analytical research, econometric evi- Attempting to achieve two objectives of the development community in dence, and country experience to ar- with one instrument is not a promis- the financial and macroeconomic gue that the "sacred cows" of financial ing strategy. A second instrument is policies underpinning Western and macro policies are still very much needed for financial stability, and the capitalist systems alive. For the most part the confusion best option is a prudential regime T arises from an inability to recognize capable of dampening financial cycles he current financial crisis has incentive conflicts and trade-offs in- of boom and bust. This is primarily a shaken the confidence of devel- herent in short-term and long-term task for financial regulation. An im- oped and developing countries responses to a systemic crisis. Policies portant pillar of such regulation is the alike in the very blueprint of financial employed to contain a crisis--often in establishment of capital requirements and macroeconomic policies that un- a rush to reestablish confidence and that can automatically be adjusted derlie the Western capitalist systems. without regard to long-term costs-- over the business cycle, providing In an effort to contain the crisis, U.S. should not be interpreted as perma- incentives for financial intermediar- authorities and many European gov- nent deviations from well-established ies to hold more liquid assets in good ernments have taken unprecedented policy positions. While governments times so that they can be run down steps of providing extensive liquidity, may end up providing blanket guar- in bad times. Provisions, leverage giving assurances to bank depositors antees or owning large stakes in the ratios, and additional capital buffers and creditors that include blanket financial sector in an effort to contain can all be designed to be countercycli- guarantees, and structuring bailout and deal with the crisis, this does not cal. By switching the basis of capital programs that include taking large negate the fact that generous guaran- adequacy requirements from levels of ownership stakes in financial institu- tees over the long term are likely to risk-weighted assets to their rates of tions. Few developing countries have backfire or that government officials growth, these measures require addi- even reintroduced capital controls to make poor bankers. tional capital and liquidity when bank prevent capital outflows. It is not sur- Financial crises often do expose lending and asset prices are rising fast, prising that many analysts are already weaknesses in the underlying incen- and relax such requirements in the declaring capitalism dead, along with tive frameworks and the regulation and downturns. the mainstream policy view associ- supervision systems that are supposed These proposals can be seen as ated with it. to reinforce them. But finance is risky alternatives or complements to mone- A new paper by Demirgüç-Kunt business, and it is naive to think that tary policies intended to prevent asset and Servén argues otherwise. Keeping regulation and supervision can--or bubbles and their bursting. Neverthe- in mind the importance of incentives should--completely eliminate the risk less, while it is politically feasible to and tensions between short-term of crises, though they can make them apply these policies and relax require- and longer-term policy responses to less frequent and less costly. An often ments in downturns, it is questionable crisis management, the paper ad- overlooked point is the importance of whether they will be as easily tight- dresses several questions about the incentives. To be effective, regulatory ened in upturns, without greater ac- implications of this crisis for financial reforms must improve the chain of countability and appropriate incentive and macroeconomic policies going incentives under which market disci- reforms for the authorities. forward: pline and official supervision operate. Despite their inherent fragility, fi- · Are blanket guarantees inevi- Reform proposals usually address the nancial systems underpin economic table to halt a systemic crisis? structure of regulation but not the in- development. The challenge for finan- · Should governments bail out centive structure of regulators, which cial sector policies is to align private and own financial institutions? is likely to limit the effectiveness of the incentives with public interest without · Should governments regulate reforms. unduly taxing or subsidizing private finance much more aggressively given Neither monetary policy nor capi- risk taking. Public ownership or overly the failures in market discipline? tal controls can substitute for well- aggressive regulation would simply · Should monetary policy target designed prudential regulation. While hamper financial development and asset prices? most observers agree that lax mon- growth. But striking this balance is · Should countries resort to capi- etary policy in the United States in the becoming increasingly complex in an tal controls to contain the crisis? early 2000s helped fuel the housing ever more integrated and globalized Crises recur in part because people bubble, trying to use monetary policy financial system. forget the lessons from the previous to prick asset price bubbles may do ones. While every crisis is different, more harm than good because identi- Asli Demirgüç-Kunt and Luis Servén. 2009. past crises provide important lessons fying and bursting bubbles in a timely "Are All the Sacred Cows Dead? Implications of that need to be learned so that policy manner is very difficult. the Financial Crisis for Macro and Financial Poli- makers need not reinvent the wheel More broadly, monetary authorities cies." Policy Research Working Paper 4807, World every time a new one erupts. in most countries face two objectives: Bank, Washington, DC. 6 WorldBankResearch Digest Beyond Doha The current Doha agenda cannot seriously changed that. Doha also a cartelized oil market interacting with adequately deal with all the would do little to tighten disciplines high demand to deliver unprecedent- challenges in trade. Is it time to aim on contingent protection in the form edly high prices. The global trading for a broad agenda? of antidumping and safeguard ac- system does not effectively regulate T tions. Such instruments, which some export restrictions in agriculture and, he recent G-20 summit commu- industrial countries adopted in past most strikingly, no mechanisms ex- niqué included a commitment recessions, are now employed by many ist for blocking collusive government by world leaders not to impose developing countries. action in the most important traded protectionist measures. The ink was Moreover, pressures for protection commodity--oil. Multilateral rules will barely dry before several countries are coming from new areas. Concerns have to address these gaps. took measures to protect domes- have already been expressed in the Is it realistic for the trading sys- tic firms. The Russian Federation United States and the European Union tem to aim for a broad agenda that imposed a number of import tariffs. about undervalued currencies that tax includes exchange rates, the environ- India slapped restrictions on steel. imports and subsidize exports, hurt- ment, state aid, and oil and agricultur- Indonesia introduced licensing to reg- ing the profitability of industries in al markets? Ironically, a bigger agenda ulate a wide range of imports. France other countries. Capital can relocate that addresses the new concerns created a fund to protect French firms. to escape these adverse effects, leav- would improve the prospects of suc- The United States and the European ing immobile, generally low-skilled cess because there would be greater Union are in the process of provid- labor to bear the brunt of these states' scope for give-and-take between the ing state aid for the domestic auto declining competitiveness. New mul- major trading countries. China will industry. Earlier, China had increased tilateral rules are needed to address have to recognize that its exchange its value added tax rebate for exports genuine trade distortions arising from rate policies can provoke a protection- and is now publicly worrying that the such exchange rates while precluding ist reaction; the United States and the renminbi is, yes, overvalued. unilateral action. European Union will have to refrain As the financial crisis has morphed As the pace of climate change from excessive recourse to contingent into a crisis in the real economy, the quickens, there is increasing talk of and environmental protectionism and world is facing a sharp and perhaps using trade as an instrument for fur- to subsidies; and emerging market prolonged economic slump. In these thering environmental objectives. The economies such as India will have to circumstances resurgent protection- most prominent climate bills in the appreciate that keeping markets open ism is a real threat, especially since U.S. Congress envisage some form of will require an effort on their part to preexisting anxieties about globaliza- trade-restrictive action against imports lower their significant trade barriers. tion are widespread. Restrictions on from countries not deemed to be tak- In the wake of the financial crisis, trade and investment would deepen ing "comparable action" to that of the the challenges on trade are becoming the recession and undermine efforts United States. The European Union more urgent. The new Bretton Woods to reduce poverty. has been contemplating similar action. process is an opportunity to rethink Recognizing these dangers, and Without multilateral rules, environ- not just the architecture for interna- to head off protectionist pressures, mental concerns could easily become tional finance but also that for inter- leaders at the G-20 summit called for an excuse for trade restrictions. national trade. How much a successful completing the Doha Development Similarly, the industrial countries Doha would deliver can be debated, Agenda of trade negotiations at the are going to be under pressure to sub- but the importance of issues that Doha World Trade Organization (WTO). But sidize declining industries, starting does not address is becoming glaringly the current Doha agenda cannot ad- with cars and trucks. Such support, re- evident. It is in this sense that the equately deal with all the challenges gardless of its merits, will adversely af- world must now look beyond Doha. facing the trading system. fect competitive conditions and distort First of all, any likely Doha deal trade. A fresh look at multilateral rules would deliver little by way of new will become necessary to discipline the market opening. It would also provide granting of such subsidies. only limited insurance against future Finally, there are challenges for reversal of trade policies. The recent collective action from agricultural trade restrictions attest to the fact and oil markets. Prices in these mar- Aaditya Mattoo and Arvind Subramanian. 2008. "Multilateralism beyond Doha." Policy Research that the WTO does not bind develop- kets have dropped sharply recently, Working Paper 4735, World Bank, Washington, ing countries' policies effectively. Even but we should not forget that only a DC. if the Doha talks had not stalled in few months ago we saw a new and ------. Forthcoming. "From Doha to the New July 2008 and had resulted in a deal, dangerous form of protectionism in Bretton Woods: A New Multilateral Trade Agen- the outcome would not have agriculture--on the export side--and da." Foreign Affairs. WorldBankResearch Digest 7 The Impact of the Financial Crisis on the Developing World Growth is forecast to decline across poorer countries (Bosnia and Herze- may gain from lower commodity prices developing regions in 2009, though govina, the Kyrgyz Republic, Moldova, on the trade side (and will likely see effects of the financial crisis differ Tajikistan). Large external financing lower inflationary pressures), but links greatly needs are creating debt rollover risks with European economies in recession T for Bulgaria, Hungary, Romania, Ser- put their industrial production at risk. hroughout the developing world, bia, Ukraine, and the Baltic states. Five The declining oil prices also mean risks growth is forecast to decelerate countries have concluded or are ne- of lower foreign direct investment and in 2009--as a result of falling gotiating deals with the International remittances from Gulf countries. For exports and remittances, stock mar- Monetary Fund for emergency financ- the region, even if oil prices recover to ket declines caused by capital flight, ing. The decline in commodity prices $65­75 a barrel, GDP per capita growth widening sovereign spreads, and poses particular problems for oil and is expected to fall below 4 percent in depreciating local currencies--though gas exporters such as Russia, whose 2009. a recession is not expected. The rever- budget balance and currency are ex- South Asia. Governments' ability to sal of the rise in fuel and food prices posed to major downward pressure. respond to the decline in aggregate is shifting terms of trade and helping GDP per capita growth is expected to demand is constrained by the terms- to ease inflationary pressure. The size fall below 3 percent in 2009. of-trade shocks of 2003­08. Large net and implications of these effects dif- Latin America and the Caribbean. Close losses from food and petroleum prices fer greatly across developing regions, integration with the United States have led to a sharp deterioration in depending on the structure of region- through trade and capital flows makes current account and fiscal balances, al economies and their integration this region particularly vulnerable to allowing little scope for countercyclical into world markets. the crisis. The worsening U.S. contrac- policies. Pakistan is particularly vul- East Asia and Pacific. The rapid trade tion is having a strong, direct impact nerable, with large fiscal and current and investment growth that has sup- on exports, foreign investment, and account deficits, rapid inflation, low ported economic development in this remittances. With net commodity ex- reserves, weak currency, and deep po- region has also made it vulnerable to porters accounting for more than 90 litical tensions. India is better placed, the downturn in global demand. Most percent of the region's GDP and popu- having a large and dynamic domestic affected will be the smaller, heavily lation, food and fuel price declines market, high savings rate, solid finan- trade-dependent economies such as are hurting terms of trade and fiscal cial sector, and proactive monetary Singapore. China has a more solid revenues. Deteriorating current ac- policy. Commodity price declines may domestic demand base and was able count balances and soaring sovereign help terms of trade and create fiscal to build up considerable buffers: $1.9 spreads have made it more difficult space for governments. The region's trillion in international reserves, a to meet foreign debt obligations, as banking sector has been relatively in- $400 billion current account surplus, shown by the recent default of Ecua- sulated from the financial crisis thanks and a balanced budget in 2008. The dor. On the upside, inflation, previous- to limited exposure to toxic assets. government has announced a $586 ly a major policy concern, has eased in But there was a significant correction billion stimulus program. Fiscal and most countries, though imported infla- in equity markets and a falloff in bank monetary intervention in the region is tion may increase as currencies depre- borrowing and equity and bond issu- helped by an easing of inflation due ciate further. GDP per capita growth is ance. GDP per capita growth is expect- to commodity price declines. Terms of expected to fall to 2 percent in 2009. ed to decline to 4 percent in 2009. trade are improving for China, though Middle East and North Africa. The re- Sub-Saharan Africa. While the re- not for the region's hydrocarbon, food, gion is relatively well positioned to gion's lack of integration into the world and raw materials exporters. Thanks weather the financial aspects of the economy insulates its banks from the largely to China, growth is expected to crisis but will suffer from commodity crisis, its economies are vulnerable remain robust, though GDP per capita price declines. Banks and investment to the drop in commodity prices and growth is forecast to fall below 6 per- companies had few toxic assets, equity slowdown in private capital flows, cent in 2009. markets have fallen somewhat less, remittances, tourism, and aid. An Europe and Central Asia. Tight links and sovereign spreads have risen less estimated 80 percent of the region's with Western Europe leave this region than in emerging markets as a group. exports are primary or semiprocessed directly exposed to the financial crisis. Oil-rich countries have built up inter- commodities. The rapid price decline Outside the Russian Federation, bank- national reserves in recent years. But will drastically curtail fiscal and export ing is dominated by Western institu- with the collapse of oil prices, current revenues, particularly in Angola, Chad, tions, many of them severely troubled. account and fiscal balances are pro- Mozambique, and Nigeria. Economies Industrial production is heavily reliant jected to decline steeply. The more on demand from Western Europe. diversified, non-oil-exporting econo- A slowdown in remittances will hurt mies--Jordan, Morocco, and Tunisia-- (continued on page 8) 8 WorldBankResearch Digest (continued from page 1) strengths and weaknesses of past pol- priority to the poorest among those Recent Policy Research icy responses. The lessons span finan- affected--while preserving the key Working Papers cial sector policies, macroeconomic physical and human assets of poor stabilization, external trade policies, people and their communities. Diffi- education and health care, and so- cult choices will be faced in addressing 4750 export Surges: the Power of a Competitive Currency cial protection. Many specific lessons the inevitable trade-offs between rapid Caroline Freund and Martha Denisse Pierola emerge, but there is space here only to crisis response and these longer-term 4753 taxation and Capital Structure: evidence from a transition economy point to some generic lessons. (Other development goals. Leora F. Klapper and Konstantinos Tzioumis articles in this issue elaborate on some 4754 market Power and the matching of trade Credit terms specific areas.) Development Research Group. 2008. "Lessons Daniela Fabbri and Leora F. Klapper The generic lessons include the from World Bank Research on Financial Crises." 4761 Carbon markets, institutions, Policies, and Research importance of an early response. The Policy Research Working Paper 4779, World Donald F. Larson, Philippe Ambrosia, Ariel fiscal cost of interventions can be Bank, Washington, DC. Dinar, Shaikh Mahfuzur Rahman, and Rebecca Entler quite large, but the cost of inaction 4762 Populist Fiscal Policy can be even larger. Other generic les- Stuti Khemani and Waly Wane sons include the importance of an un- 4766 in Search of the missing Resource Curse Daniel Lederman and William F. Maloney derstanding of incentives in designing 4770 Crises, Capital Controls, and Financial policy responses, the importance of (continued from page 7) integration Eduardo Levy Yeyati, Sergio L. Schmukler, and spending composition in designing a Neeltje Van Horen fiscal stimulus or adjustment program, The Impact of the Financial 4773 Sovereign Rents and the Quality of tax Policy and Administration and the importance of sound infor- Crisis on the Developing Stephen Knack mation on what is happening on the World 4780 Reform and inequality during the transition: An Analysis using Panel Household Survey ground as the crisis unfolds. Data, 1990­2005 If there is one lesson that stands relying heavily on tourism--Kenya, Branko Milanovic and Lire Ersado 4787 Pension Funds and Capital market out, however, it is this: that the short- Mauritius, the Seychelles--can also Development: How much bang for the buck? term responses to a crisis cannot expect a sharp drop in earnings. Re- Claudio Raddatz and Sergio L. Schmukler ignore longer-term implications for mittances to Africa, 77 percent of 4788 Drivers and obstacles to banking Smes: the Role of Competition and the institutional development in all its dimensions. The which come from the United States Framework macroeconomic stabilization response and Europe, may also suffer. Foreign Augusto de la Torre, M. S. Martínez Pería, and Sergio L. Schmukler must be consistent with restoring the direct investment inflows are highly 4791 Does inflation targeting matter for output growth process and thus the pace of concentrated, primarily in Nigeria Growth? evidence from industrial and emerging economies poverty reduction. Financial sector and South Africa. Even these larger André Varella Mollick, René Cabral Torres, policies need to balance (understand- economies are susceptible to greater and Francisco G. Carneiro 4792 explaining enterprise Performance in able) concerns about the fragility of risk aversion by investors. The last Developing Countries with business Climate the banking system with the needs for quarter of 2008 saw a drop in portfolio Survey Data Jean-Jacques Dethier, Maximilian Hirn, and sound longer-term financial institu- investments and a 40 percent decline Stéphane Straub tions. And the social policy response in stock market values. While aid tends must provide rapid income support to to be more stable than private invest- working Papers can be downloaded at http://econ.worldbank.org to download the World Bank Research E-Newsletter, those in most need--giving highest ment, a cutback is possible. go to Data & Research at http://www.worldbank.org the world bank Research Digest is a quarterly publica- the Research Digest is financed by the bank's editorial Committee: Jean-Jacques Dethier (managing tion disseminating findings of world bank research. Research Committee and managed by DeCRS, the editor), Asli Demirgüç-Kunt, and Alan Gelb. 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