development outreach: december 2009 - growing out of crisis

8/14/2019 Development Outreach: December 2009 - Growing Out of Crisis

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Outreach

D E V E L O P M E N T

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

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Christopher NealE X E C U T I V E E D I T O R

MARY MCNEILFOUNDING EDITOR

EDITORIAL BOARD

SWAMINATHAN S. AIYARECONOMIC TIMES OF INDIA, NEW DELHI, INDIA

MICHAEL COHENNEW SCHOOL UNIVERSITY, NEW YORK, USA

PAUL COLLIEROXFORD UNIVERSITY, OXFORD, UK

JOHN GAGESUN MICROSYSTEMS, PALO ALTO, CALIFORNIA, USA

JOSEPH K. INGRA MPERUGIA, ITALY

KWAME KARIKARISCHOOL OF JOURNALISM AND COMMUNICATIONS,THE UNIVERSITY OF GHANA, LEGON, GHANA

VIRA NANIVSKANATIONAL ACADEMY OF PUBLIC ADMINISTRATION,KIEV, UKRAINE

PEPI PATRONCATHOLIC UNIVERSITY, LIMA, PERU

J. ROBERT S. PRICHARDTORSTAR, TORONTO, CANADA

RAFAEL RANGEL SOSTMANNMONTERREY TECH UNIVERSITY SYSTEM, MONTERREY, MEXICO

VIVIENNE WEECENTRE FOR ENVIRONMENT, GENDER AND DEVELOPMENT, SINGAPORE

Development OUTREACH is published three times a year by the WorldBank Institute and reflects issues arising from the World Banks manylearning programs. Articles are solicited that offer a range ofviewpoints from a variety of authors worldwide and do not representofficial positions of the World Bank or the views of its management.

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World Bank InstituteSanjay PradhanVice PresidentThe World Bank1818 H Street NWWashington, DC 20433, USA

ISSN 1020-797X 2009 The World Bank Institute

This magazine is printed on recycled paper, with soy-based inks.

A B O U T T H I S I S S U E

very crisis has its lessons. A global financial andeconomic convulsion of the magnitude we have

just experienced should offer more lessons thanmost. That is why we have selected Growing Out ofCrisis as the theme for this issue of Development

Outreach.As 2009 draws to a close, policymakers in all coun-

tries are assessing the fault lines in their economicman-agement systems, and working together in internationalforums such as the G-20and IMF/World Bankmeetings,among others, to define an agenda for reform, and toimprove international coordination systems.

We asked some of the worlds leading economicthinkers, as well as regional experts and policymakers,to discuss the impact of the crisis from different per-spectives and in different parts of the world, and toreflect on changes at national and international levelsthat would better protect us from the next crisis.

World Bank President Robert Zoellick, in an addressat Johns Hopkins University in September, pointed to the

vital role of developing economies in leading the worldoutof this crisis.Indeed, this is perhaps themajor water-shed produced by the crisis. The emerging market coun-tries have arrived, the G-20 has replaced the G-7, andmore hands are on the levers of global economy.

Not least, this has had implications for internationalfinancial institutions. The World Bank Group commit-ted itself to lending $100 billion over three yearsto pro-

vide a counter-cyclical stimulusto the developing world.The IMF has also tripled itslending to $750 billion. Both

institutions must seek additional support to cover thesenew demands, and both face pressure to reform theirgovernance and representation to reflect shifting globaleconomic influences.

The World Bank Institute, whose mission includescapacity building for government officials and otherstakeholders, responded to the economic and financialcrisis by hosting videoconference discussions amongpolicymakers in developing countries finance, planningand trade ministries, as well as central banks.

A series of seminars, Pathways to Development, will fol-low, aimed at drawing further lessons to help countriesgrow out of crisis.

For his guest editing of this issue of DevelopmentOutreach, I would like to thank Raj Nallari, LeadEconomist with WBIs Growth and Crisis Unit.

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SPECIAL REPORTGROWING OUT OF CRISIS

2 After the CrisisR O B E R T B . Z O E L L I C K

6 Growing Out of CrisisGuest EditorialR A J N A L L A R I

8 The Economic and Fiscal Consequencesof Financial Crises: North and SouthC A R M E N M . R E I N H A RT

13 Shock Producers and Shock Absorbers inthe CrisisH A N S - W E RN E R S I N N

16 The Crisis and the Worlds PoorestM A R T I N R A V A L L I O N

19 Growth Is Disappearing and May NotRecover in the Medium RunV L A D I M I R G L I G O R O V

22 South Africas Policy May Offset theFinancial DownturnB R I A N K A H N

25 Small States Face Big ChallengesD W I G H T V E N N E R

29 Policy Responses to the GlobalEconomic CrisisJU ST IN YI FU LI N

34 Coming Out of Recession: The roleof business in alleviating povertyV . K A S T U R I R A N G A N A N D D J O R D J I J A P E T K O S K I

37 Trade Openness Is Now More ImportantThan EverA N N E O . K R U E G E R

39 The Imperative for Improved GlobalEconomic CoordinationJO SE PH E . ST I GL I TZ

43 Lender of Last Resort and GlobalLiquidity: Rethinking the systemM A U R I C E O B S T F E L D

47The Dollar DilemmaB A R R Y E I C H E N G R E E N

50 Government Actions and Interventions:More harm than good?JO HN B. TAY LO R

54 KNOWLEDGE RESOURCES

55 BOOKSHELF

56 CALENDAR OF EVENTS

OutreachD E V E L O P M E N T

V O L U M E E L E V E N , N U M B E R T H R E E D E C E M B E R 2 0 0 9

P A G E 1 6 P A G E 3 2 P A G E 3 9

CURRENT CRISIS:IMPACT AND POLICY RESPONSES

RETHINKING POLICIES

AU CONTRAIRE


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2 Development Outreach W O R L D B A N K I N S T I T U T E

BY ROBERT B. ZOELLICK

Excerpted from a speech delivered at the Paul H. Nitze School of

Advanced International Studies of the Johns HopkinsUniversity, September 28, 2009.

G R E A T U P H E A VA L S produce shock waves that widencracks in political, economic, and security orders.Sometimes the old orders break. Yet it can be in the power

of leaders and peoples to shape the directions of change.

Outcomes are not predetermined

I N 2 0 0 9 , we are living through an upheaval that is chang-ing our world. What will be its implications for the future?

Thelast 20 years have witnessed a huge economic shift.The breakdown of the planned economies in the SovietUnion and Central and Eastern Europe, the economicreforms in China and India, and the export-driven growthstrategies of East Asia all contributed to a world marketeconomy that vaulted from about 1 billion to 4 or 5 billion

people. This shift offers enormous opportunities. But ithas also shaken an international economic system forgedin themiddle of the20th century with patched-up changesin the decades since.

Already, we can see potential shifts in power and insti-tutions and international cooperation. In part, the shifts

will depend upon how the parties adapt to new circum-stances; in part, upon the rapidity of the recovery; in part,upon changes in whoholds theworlds capital, technology,and human resources and what they do with them; in part,upon how countries cooperateor do not.

What are the perceptions and realities

of power after this crisis?T H E C U R R E N T A S S U M P T I O N is that the post-crisis politi-cal economy will reflect the rising influence of China andIndia, and of other large emerging economies. Supposedly,the United States, the epicenter of the financial crisis, willsee its economic power and influence diminish.

Indeed, today, China acts as a stabilizing force in theglobal economy. Together, China and India account for 8.5percent of world output. They and other developing coun-tries are growing substantially more rapidly than devel-oped countries.

And yetChinas future is not yet determined. Its rapidrecovery in 2009 wasfueled by an expansion of credit of 26percent of GDP in the first eight months of this year. Thisflood is now easing, and authorities arelikely to limit it fur-

ther for fear of effects on asset prices, asset quality, andeventually general inflation. China still faces big uncer-tainties in 2010.

The United States, in turn, has been hit hard by the cri-sis. But America has a culture of resilience to set-backs,adapting to new circumstances and remaking itself. Thefuture for the United States will depend on whether andhow it will address large deficits, recover without inflationthat could undermine its credit and currency, and over-haul its financial system to preserve innovation whileadding to safety and soundness.Understanding shiftingpower relations is fundamental for shaping the futureas

the Bretton Woods delegates appreciated. The politicalbasis for that system was forged through a shared experi-ence in failed responsibility after World War I and a clearassessment of power after World War II. Change thosepower relationsand the nature of the markets that con-nect themand the system looks out of touch.

Will the U.S. dollar remain thepredominant reserve currency?

T H E B R E T T O N W O O D S C U R R E N C Y S Y S T E M gave way in1973 to floating rates, with the dollar as the worlds mainreserve currency. For all the questions about the dollars

reliability as a reserve currency, its value strengthenedduring the crisis as it offered investors a safe haven. Butthe United States would be mistaken to take for grantedthe dollars place as the worlds predominant reserve cur-rency. Looking forward, there will increasingly be otheroptions to the dollar.

AFTER THE CRISIS


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D E C E M B E R 2 0 0 9 3

The Bretton Woods system was forged by 44 countriesat a time when power was concentrated in a small numberof states. The great waves of decolonization were just stir-ring; the few developing countries were seen as objects,

notsubjects, of history. That world is long passed. Thenewrealities of political economy demand a different system.

What will be the role of developingcountries after the crisis?

T H E C R I S I S H A S U N D E R S C O R E D the growing importanceof the large emerging economies, especially China andIndia, but others as well. In effect, the world economy isbeing rebalanced toward the relative shares of some twohundred years ago, before the industrial revolution, plus anew North America.

The rising developing economies should play a key role

in the recovery. Most forecasters expect demand to betepid, with a pullback by the U.S. consumer. Many devel-oping countries could expand demand if they can getaccess to financing. They have fiscal space to borrow, butcannot get the volumes they need at reasonable prices

without crowding out their private sectors. Moreover, themiddle-income countries are home to 70 percent of the

worlds extreme poor. The World Bank Group and theregional development banks can assist.

The World Bank Group can offer a counterweight tofinancial and trade protectionism by supporting this devel-opment globally. We have launched a new Asset

Management Corporation, through IFC, our private sectorarm, to invest in banks, equity, infrastructure, and debtrestructuring. We have a parallel effort to supportand investin the development of local currency bond markets.Longer-term investorssuch as sovereign and pensionfundsnow recognize that developed markets pose risks,too, and developing markets can offer good growthprospects.

Coming out of this crisis, we have an opportunity toreshape our policies, architecture, and institutions. Wehave an opportunity to craft a new global system for a 21stcentury of Responsible Globalizationone that wouldencourage balanced global growth and financial stability,

embrace global efforts to counter climate change, andadvance opportunity for the poorest. It means expandingthe benefits of open markets and trade, investments,competition, innovation, entrepreneurialism, growth,informationand debates on ideas. It must be a globaliza-tion that is both inclusive and sustainableexpandingopportunity with care for the environment.

Yet it wont happen by itself

AT T H E G-20 S U M M I T I N L O N D O N I N A P R I L , leadersstared into an economic abyss. The danger today is not

freefall, but complacency. As the crisis wanes, it will beharder to press countries to cooperate in building backbetter. Peer review of a new Framework for Strong,Sustainable and Balanced Growth agreed at theApril G-20Summit is a good start, but it will require a new level ofinternational cooperation and coordination, including anew willingness to take the findings of global monitoringseriously. Peer review will need to be peer pressure.

Global finance and currencies. The trading system.Inclusive and sustainable development. Climate change.States struggling with fragility and conflicts. And a host ofother security issues. Each topic is important on its own.But each interconnects with the others.

The countries of the world will never deal effectivelywith this agenda unlessthey cooperate.The economicmul-tilateralismof anotherage doesnot reflect todays realities.

We need to modernize multilateralism and markets.As agreed at the Pittsburgh Summit, the G-20 should

become the premier forum for international economiccooperation among the advanced industrialized countriesand rising powers. But it cannot be a stand-alone commit-tee. Nor can it ignore the voices of the over 160 countriesleft outside.

The G-20 should operate as a Steering Group acrossa network of countries and international institutions. It

could recognize the interconnections among issues andfoster points of mutual interest.Thequestion is whether leaders can cooperatein steer-

ing the changes. They will be drawn to the interests of thenational publics they represent, as they should. Yet theyalso will be challenged to recognize and build commoninterests, not only case-by-case, but through institutionsreflecting a Responsible Globalization.

Bretton Woods is being overhauled before our eyes.This time, it will take longer than three weeks in NewHampshire. It will have more participants. But it is just asnecessary. Thenext upheaval, whatever it may be,is takingform now. Shape it or be shaped by it.

Robert B. Zoellick is President of The World Bank Group.


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D E C E M B E R 2 0 0 9 5

SPECIAL REPORT

BY RAJ NALLARI

H O W CO UL D SMAL L L O SSES on subprime housing loans intheUnited States, estimated at about $100 million in early 2007,lead to a global financial and economic crisis? Worldwide stockmarkets plunged and housing values declined sharply during2007-08; and the IMFhas projected that output lossesare like-ly to be about$4.7trillion between 2008and 2015.Most experts

were blind-sided by the magnitude and speed with which thisfinancial crisis, which originated in the U.S., spread to the restof the world. Large investment banks, big corporations, mil-

lions of jobs, and about $1 trillion of private capital flows todeveloping countries evaporated within days of the collapse ofLehman Brothers on September 12, 2008. Some argue that ifLehman had been bailed out, the U.S. financial system wouldnot have melted down and, consequently, a global recessioncould have been avoided. Others, such as Kenneth Rogoff (TheEconomist, 9/12/09), argue that even if Lehman had been savedit would still have had to be sacrificed later, along with otherinvestment banks, because the system had exceeded sustain-able levels: trillions of dollars had been borrowed against anasset bubble in stock and house prices.

Inthisissue ofDevelopment Outreach, we asked experts with

diverse perspectivesto address thekey questions that concernthe developing countries. These questions include: what werethe prevailing economic conditions when the crisis struck;

what was the impact during the first year of the global crisis;what policies have the developing countries taken inresponse; and what effects will those policies have on output,employment, poverty, and public finances. In this overviewarticle, we provide our own thoughts on these questions.

What were the economic conditionsbefore the crisis?

A P E R F E CT S T O R M WA S B R E W I N G as U.S. and European

housing defaults began piling up in late 2006, oil prices dou-bled during late 2007 and early 2008, and rice, wheat, andcorn prices jumped by 40-50 percent during thesame period.

Sustained global growth between 2000 and 2007, especial-ly in emerging and developing economies, had catalyzeddemand for many commodities, including oil, metals, andfood. Atthe sametime,supply had beenslow to catch up to thisgrowing demand, causing prices to rise. Beginning in 2006, anumber of other factors also contributed to the rapid jump infood prices. For example, unfavorable weather conditions

reduced harvest yields; rising biofuel production in advancedeconomies jacked up corn prices as well as feedstock costs; therise in oil and energy prices boosted production costs for foodcommodities through higher prices for transportation fuelsand fertilizer; and the growing use of export restrictions byfood exporters as a way of raising domestic food supplies andlowering domestic prices has put pressure on world prices,contributingsubstantially to the run-up in rice pricesin 2008.

Finally, the bursting of the housing bubbles in the U. S. andEuropein2007ledtoasurgeindefaultsandforeclosures,1whichresulted in a plungein the pricesof mortgage-backedsecurities.These financial losses have left many financial institutions withtoolittlecapital relative to their debt. They have,therefore, been

unable to provide the credit required foreconomic growth.Many other culprits have also been implicated and it is more

than a government or regulatory failure. Markets also failed. Along period of abundant liquidity, lowinterest rates,and a glob-al search-for-yield led to rising asset prices. In addition,there was a steady build-up of macroeconomic imbalances as

Asian countries and oil-importers were pursuing policies offoreign exchange reserve accumulation. All thiswas taking placeat a time when financialsystems were going globalandintegrat-ing through new technologies. Complex, nontransparent finan-cial instruments were mispriced and levels of risk were misun-derstood. Regulators in some cases failed to respond to, and in

other cases facilitated the build-up of imbalances. Serviceproviders, including credit rating agencies, loan originatorsand payment collectors were also involved.

When Lehman Brothers went belly-up, the global financialsystemitself wason thevergeof collapse.Globalization, definedas the increasingly free flow of ideas, people, goods, services,and capital that leads to the integration of economies and soci-eties, has become a major force for global change. It has alsoadded to the number of channels through which shocks can betransmitted across borders more quickly. As shocks havebecome larger and more frequent, economies from North andSouth have to move in lock-step. This co-dependence reducesthe ability of individual economies to manage their way out of a

crisis,especially when it is thelargest economy that is transmit-ting the shock.

What has been the immediate impactof the crisis?

WO R L D O U T P U T D E C L I N E D by an unprecedented 2.25 per-cent (annualized) in the last quarter of 2008; and global tradeand industrial activity have fallen substantially sinceNovember 2008. Allthe major industrial economies entered a

GROWING OUT OF CRISIS

Guest Editorial


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period of deep recession, and several emerging markets weresputtering in late 2008. Growth in emerging and developingeconomies has decelerated abruptly to 3.25 percent, mostlybecause ofexternal pressureslower foreign demand, reversalof capital inflows, and plunging commodity prices. Anemicglobal growth has reversed the commodity price boom andlowered inflation. These price declines (except for gold) havedampened growth prospects for a number of commodity-exporting economies.

In the first few months of the global crisis, there were mas-sivelay-offs of workersin Chinas garment, toy and electronicsmanufacturing sectors, in Bangladeshs jute mills, inCambodias garments industry, and in Indias diamond pol-ishing, textile and garment firms. Martin Ravallions article inthis issue describes how more than 50 million peoplemay havebeen pushed below thepovertylineduring the first few monthsof the crisis. If the Asian crisis is any indication, poverty levelsarelikely to be much higher in several of the affected countriesand to remain so, long after the global economy recovers.

Professor Sinns essay makes an interesting point: that theU.S. was the mainshock producerbecause it reduced its importsmore than its exports during late 2008 and early 2009. To a

lesser extent, China, Brazil, the United Kingdom, and SouthKorea followed a similar practice. In contrast, Germany, Japanand Russia were the main shock absorbers as their importsexceeded exports during the same period.

How did policy makers react to theglobal economic crisis?

P O L I C Y M A K E R S U N D E R S T O O D early on that the currentglobal downturn was far from your normal garden-varietyrecession. The central banks were the first to react, while

commercial banks were sharply curtailing credit in the face ofglobal deleveragingthere was monetary easing as interestrates were cut dramatically, liquidity provision was steppedup, limits to deposit insurance were expanded, and specialcredit lines were set up for use by troubled banks.

The size of governments expanded overnight. First, sever-al crisis-affectedand crisis-pronecountriesdirectly support-ed their financial sectors by injecting funds to recapitalizebanks, insurance companies and investment banks, especial-ly those deemed too big to fail. For example, theInternational Monetary Fund (IMF) estimates that advancedG-20 economies spent about 3.5 percent of their GDP on suchfinancial support. Hungary, Poland, and Ukraine took similar

steps in providing direct support to the financial sector.Second, as growth slowed in almost all countries, declines inthe price of equities, properties, and commodities led toreductions in government revenues and private and publicspending. Aggregate demand had to be shored up by fiscalstimulus packages. Third, the losses on funded pensionschemes increased governments fiscal liabilities. For exam-ple, countries in the Eastern and Central Asian region haveautomatic stabilizers such as unemployment benefits. Fourth,several countries used public resources to bail out their trou-

bled industries (for example, General Motors and Chrysler inthe U.S. and the French auto industry). Fifth, the govern-ments became market makers. However, despite thisexpansionary fiscal policy, JohnTaylors article details why theU.S. and European governments fiscal (and monetary) poli-cies may not work and could actually exacerbate the problem,including prolonging the recession.

As a result,public financeshave deteriorated in a numberofadvancedand developing countries, and thishas increased fis-

cal risks and raised premiums for government-issued bonds.Early IMF estimates for advanced economies are that fiscalbalances could decline by about 8 percent of GDP between theend of 2007 and the end of 2009, and by 5 percent of GDP inthe case of emergingeconomies. There is likely to be a dramat-ic increasein publicdebt levels in both advanced and develop-ing economies. Carmen Reinharts paper, in this issue, isbased on an historical analysis which concludes that this crisisis essentially no different from past crises and that they alwaysend with deficit, debt, and default. But small open economiessuch as the Caribbean and Pacific Islands are highly dependenton external economic conditions and on imports. As Dwight

Vennerspiece argues, these countriescannot use fiscal stimu-

lus packages to respond to an external shock since theirincreased spending will fully leak out through higher imports.

To date, few countries have taken major steps toward tradeprotectionism, despite thefact that exports fell by as much as 23percent in China and other emerging markets. However, somehave targeted export firms for subsidies and included protec-tionist measures in their fiscal stimulus packages. AnneKruegers essay makes a strong case for open trade policies,since resumption of global trade is imperative for economicrecovery.She arguesthat with theliquiditycrunch, internation-al traders needed more secured means of payment and there isa demand for newer trade-finance instruments than the tradi-

tionalletters ofcredit.Moreover, countrieshave refrainedfrombeggar-thy-neighbor competitive exchange rate devaluationsto ensure their own exports. Brian Kahns essay details thepol-icy mix that was used to stabilize the South African economy.

Joseph Stiglitzs essay focuses on international coordina-tion issues. This is a global crisis and therefore there is a needfor collective action, such as the attempts made by the G-20since November 2008. Fiscal stimulus in the U.S. will not be

very effective if the Euro zone countries do not stimulate theireconomies. When all countries act in concert, the amount ofglobal fiscal stimulus needed is much less, and the worldeconomy will recover much sooner.

What is the outlook for the worldeconomy after one year of meltdown?

T H E R E W E R E S O M E S I G N S O F R E C O V E R Y or green shootsintheU.S.and a few otheradvancedeconomiesbetweenJuly andSeptember 2009, but unemployment is still rising in the

Western world. After increasing between 2000 and 2007, worldoutput growth slowed down to about 3 percent in 2008 and isprojected to decline by 1 percent in 2009. Underlying theseaverages is the fact that advanced economies, which grew at


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D E C E M B E R 2 0 0 9 7

about 0.6 percent in 2008, are projected to decline by 3.4 per-cent in 2009, and begin to show some recovery in the year 2010.The reason for this low performance is that the financial systemin the U.S. and Europe has been damaged and the fiscal burdenof the economic and financialcrisis is quickly mounting.On theother hand, emergingand developing economiesareexpectedtogrow at about 6 percent on average in 2009, with China, India,and other Asian countries pulling the world wagon. Conversely,there have been steep declines in output in Central and Eastern

Europe, Russia, Mexico, and a few other countries. VladimirGligorovs essay on Southeastern European countries points outthat output declines in crisis-affected Eastern European coun-tries may never come back to the trend growth rate.

How can countries sustain their economic recovery? Thereisaneedtorecoverthefundsreleasedasbail-outsandtoensureliquidity. Central Banks need to be aware that their balancesheets have expanded because of measures they took to achievemonetary easing, and their debt levels have risen. There is anincreased likelihood of a sudden jump in inflation. But policymakers should not be tied too strongly to inflation-targetingand they must learn to better manage asset bubbles. Interestrates have to be increased gradually as the economy gains

strength. Asian central banks have to be more prudent in for-eign exchange reserve accumulation and move away from cur-rency manipulation. More and more countries are moving tointermediate exchange rate regimes such as managed float, tar-get bands, and basket pegs. On the fiscal side, highest priorityshould be assigned to bringing down deficits and debt levelsthat were incurred in fighting the recentrecession. Subsidiestolarge auto industries and financial firms put similar entities indeveloping countries at a disadvantage.

Fiscal discipline has to be reinstated and governments willhave to reform health and pension systems. Financial regula-tions are urgently needed to deal with institutions such as

banks, investment banks, insurance, housing-finance enti-ties and so called too-big-to-fail firms. Further, prudentialregulations need to be counter-cyclical if they are to be suc-cessful in managing creditgrowthand asset bubbles. In devel-oping countries, a lack of financial intermediation is anunderlying cause of global macroeconomic imbalances.

For almost a decade, international economic observers haveadvised that the world economy needs a major adjustment.Sustained global growth requires that the U.S. cut back on itsdomestic demand and let the dollar depreciate to increase netexports,which willenable theU.S. to improve itscurrentaccountbalances. Conversely, China and other Asian countries shouldstimulate domestic demand andlettheir exchangerates appreci-

ate. Such a rebalancing of aggregate demand, away from the U.S.and toward China, would help sustain a global recovery. If thisrebalancingdoes nothappen quickly,global growth may be flat.

With the U.S. at the epicenter of the financial crisis, coun-tries such as the BRICS (Brazil, Russia, India, China, South

Africa) and oil producers holding large foreign exchangereserves primarily in U.S. dollars began to worry about theefficacy of the dollar as the main reserve currency. BarryEichengreens essay discusses why the euro and the yen mayfind it hard to dislodge the dollar as the reserve currency.

This crisis can prompt a structural transformation thatcould change the economic history of the world. The develop-ingeconomies, which together account forabout 50 percent of

world output, are on the rise and playing a major role in theworld recovery. Some of them have the fiscal space to borrow,but the volume of financing they need at fair prices, withoutcrowding out the private sector, may not be available. Toaddress such impediments, the World Bank has set up a new

Asset Management Corporation through its private sector

wing (the International Finance Corporation) to invest inbanks, equity, infrastructure, and development of local cur-rency bond markets, and to facilitate debt restructuring.

Conclusion

I S T H E F I N A N C I A L C R I S I S O V E R and could it happen again?National supervision and regulatory systems were inadequateto manage transnational institutions, such as LehmanBrothers, Citibank, AIG, Dexia Bank and others.Consequently, national authorities will have to pay closerattention to risk-taking behaviors, to limit leveraging, tightencapital regulation, attend to liquidity supervision as well as

supervision of complex cross-border financial institutions,and to improve transparency of transactions.

The crisis has also revealed deficiencies in internationalcoordination such as the IMFs weak surveillance of advancedeconomiesand itslack of enforcementauthority. National andglobal solutions are needed to regulate capital flows and pre-

vent systemic and global risks by reining in financial firmsand conglomerates; to ensure higher international standardsfor credit rating agencies; and to eliminate inconsistencies innational legal frameworks. There is even talk of creating aglobal college of supervisors.

How can we deter another crisis? One way is for central

banks not only to keep inflation low but also to manage assetbubbles early on.Rapid growthin credit should be tracked andcarefully analyzed to ensure that it is in line with financialdevelopment and not fueling asset price increases. Some

would prefer that the early warning systems of macro- andmicro-prudential indicators be further developed. However,each financial crisis is different and such indicators may notbe

very useful in predicting a banking or financial crisis becausethey do not take into account the inter-linkages betweencredit flows to various sectors and issues of too-big-to-failconglomerates and cross-border financial flows.

Raj Nallari is Lead Economist with the World Bank Institute,

Growth and Crisis Unit.

Endnote

1 It is estimated that in the United States there were almost 7 million hous-

ing loans under water and close to default, each loan averaging about

$300,000; this totals to $2.1 trillion. In addition, potential defaults on credit

card payments, student and car loan payments are estimated to be in the

range of about $10-12 trillion. The government could have directly taken over

these bad housing loans and loans held potential defaulters but moral hazard

(rewarding bad behavior will incentivize even non-defaulters to default on loan

payments) can exacerbate the problem.


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BY CARMEN M. REINHART

The Ds: Sharp economic downturns follow banking crises;

with government revenues falling, fiscal deficits worsen; deficitslead to debt; as debts pile up rating downgrades follow. For the

most fortunate countries it does not end in default.

S I N C E T H E S U B P R I M E C R I S I S B E G A N to unfold in the sum-mer of 2007 and escalated in the early fall of 2008, a cursoryreading of the global financial press would lead to the logical

conclusion that the world economy is moving throughuncharted waters. There is little need to convince anyone thatfinancial crises are associated with economic downturns andsevere dislocations in financial markets.

In a recent paper with Kenneth S. Rogoff we examined theinternational experience with episodes of severe bankingcrises to identify empirical similarities as regards the depth,

duration, and characteristics of the economic slump followingthe crises.1 Our findings in that paper can be summarized asfollows:

SPECIAL REPORT

The Economic and Fiscal

Consequences of Financial CrisesNorth and South


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I Financial crises are protracted affairs.I Asset market collapses are deep and prolonged.I Real housing price declines average 35 percent stretched

out over six years.I Equity price collapses average 55 percent over a downturn

of about three and a half years.I There are profound declines in output and employment.I The unemployment rate rises an average of 7 percentage

points over the down phase of the cycle, which lasts four

years on average.I Real GDP per capita falls (from peak to trough) an average

of more than 9 percent, and the duration of the downturnaverages roughly two years.

I The financial crisis has significant adverse consequencesfor government finances.

I Tax revenues shrink as the economic conditions deterio-rate, the fiscal deficit worsens markedly, and the real valueof government debt explodes, rising an average of 86 per-cent in the major postWorld War II episodes.

In this article I elaborate on these points and follow up with asketch of how the crises and their ramifications affectedsovereign risk in the aftermath of the crisis episodes.

The downturn

I T I S N O W B E Y O N D C O N T E N T I O N that the present U.S.financial crisis is severeby any metric. Asa result, we focus on

systemic financial crises: the big five advanced economycrises (Spain 1977, Norway 1987, Finland 1991, Sweden 1991,and Japan 1992) plus a number of famous emerging marketepisodes: the 19971998 Asian crisis (Hong Kong, Indonesia,Korea, Malaysia, the Philippines, and Thailand); Colombia,1998; and Argentina 2001. Central to the analysis are histori-cal housing price data, which can be difficult to obtain and arecritical for assessing the crisis episode. We also include twoearlier historical cases for which we have housing prices,

Norway in 1899 and the United States in 1929.Figure 1 looks atthe bust phase in housing price cyclessur-

rounding banking crises, including the current episode in theUnitedStates anda numberof other countriesnow experienc-ing banking crises: Austria, Hungary, Iceland, Ireland, Spain,and the United Kingdom. Ongoing crises are in dark shading,past crises are in light shading. The cumulative decline in realhousing prices from peak to trough averages 35.5 percent.2

The most severe real housing price declines were experiencedby Finland, the Philippines, Colombia and Hong Kong. Theircrashes were 50 to 60 percent, measured from peak to trough.The housing price decline experienced by the United States todate during the current episode is already more than twice

that registered in the U.S. during the Great Depression. Theduration of housing price declines is quite long, averagingroughly six years.

As illustrated in Reinhart and Rogoff (2009a), the equityprice declines that accompany banking crises aresteeper than

D E C E M B E R 2 0 0 9 9

Sources: Reinhart and Rogoff (2009a).

FIGURE 1: PAST AND ONGOING REAL HOUSE PRICE CYCLES AND BANKING CRISES: PEAK-TO-TROUGH PRICE DECLINES (LEFT PANEL) AND YEARSDURATION OF DOWNTURN (RIGHT PANEL)

6 years-35.5 percent

PERCENT DECLINE

ONGOING

DURATION IN YEARS

Austria, 2008Hungary, 2008

US, 1929UK, 2007Iceland, 2007Malaysia, 1997Thailand, 1997Korea, 1997Ireland, 2007Norway, 1899Argentina, 2001US, 2007Sweden, 1991Spain, 1977Historical AverageJapan, 1992Norway, 1987Indonesia, 1997

Finland, 1991Colombia, 1998Philippines, 1997Hong Kong, 1997


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housing price declines, if somewhatshorter lived. The average historicaldecline in equity prices is 55.9 per-

cent, with the downturn phase of thecycle lasting 3.4 years. Notably, dur-ing the current cycle, Iceland and

Austria have already experiencedpeak-to-trough equity price declinesfar exceeding the average of the his-torical comparison group.

Figure 2 shows increases in unem-ployment rates across the historicalepisodes. On average, unemploymentrises for almost five years, with anincrease in the unemployment rate ofabout 7 percentage points. None of

the postwar episodes rivals the rise inunemployment of over 20 percentagepoints experienced by the UnitedStates during the Great Depression.

Although Figure 2 indicates thatthe emerging markets, particularlythose in Asia, have done better interms of unemployment than theadvanced economies (Figure 2), thereare well-known data issues in com-


Sources: Reinhart and Rogoff (2009a).

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)

Source: WHO 2003

COUNTRY Years before the crisis Peak deficit (year) Increase (-decrease)

in the fiscal deficitCENTRAL GOVERNMENT BALANCE/GDP

Source: Reinhart and Rogoff (2009b).*Spain was the only country in our sample to show an increase (modest) in per capita GDPgrowth during the post-crisis period.

Argentina, 2001

Chile, 1980

Colombia, 1998

Finland, 1991

Indonesia ,1997

Japan, 1992

Korea, 1997

Malaysia, 1997

Mexico, 1994Norway, 1987

Spain, 1977

Sweden, 1991

Thailand, 1997

-2.4 -11.9 (2002) 9.5

4.8 -3.2 (1985) 8.0

-3.6 -7.4 (1999) 3.8

1.0 -10.8 (1994) 11.8

2.1 -3.7 (2001) 5.8

-0.7 -8.7 (1999) 9.4

0.0 -4.8 (1998) 4.8

0.7 -5.8 (2000) 6.5

0.3 -2.3 (1998) 2.65.7 -2.5 (1992) 7.9

-3.9 -3.1 (1977) -0.8

3.8 -11.6 (1993) 15.4

2.3 -3.5 (1999) 5.8

TABLE 1: FISCAL DEFICITS

4.8 years7 percent

PERCENT INCREASE DURATION IN YEARS

0 5 10 15 20 25 0 2 4 6 8 10 12

Malaysia, 1997

Indonesia, 1997

Japan, 1992

Thailand, 1997

Philippines, 1997US, 2007

Hong Kong, 1997

Norway, 1987

Korea, 1997

Argentina, 2001

Historical Average

Sweden, 1991

Spain, 1977

Colombia, 1998

Finland, 1991

US, 1929


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paring unemployment rates across countries. Widespreadunderemployment in many emerging markets and the vastinformal sector arenot captured in theofficial unemploymentstatistics.

As to real per capita GDP, the average magnitude of thedecline is 9.3 percent. The declines in real GDP are smallerfor advanced economies than for emerging markets. A proba-ble explanation for the more severe contractions in emerging

market economies is that they aremore affected by abrupt reversals inthe availability of foreign credit. Whenforeign capital comes to a suddenstop, to use the phrase coined byGuillermo Calvo, economic activityheads into a tailspin.3 The cycle frompeak to trough in GDP is much shorter,two years.

Deficits

D E C L I N I N G R E V E N U E S A N D H I G H E R

E X P E N D I T U R E S owing to a combina-tion of bailout costs and higher trans-fer payments and debt servicing costshave led to a rapid and marked wors-ening in the fiscal balance. Theepisodes of Finland and Sweden standout in this regard, as the latter wentfrom a pre-crisis surplus of nearly 4percent of GDP to a whopping 15 per-

cent deficit-to-GDP ratio.

Debt

F I G U R E 3 S H O W S T H E R I S E in real government debt in thethree years following a banking crisis. The deterioration ingovernment finances is striking, with an average debt rise ofover 86 percent. We use the percentage increase in debt,rather than debt-to-GDP, because steep output drops some-times complicate interpretation of debtGDP ratios. As

D E C E M B E R 2 0 0 9 11

Sources: Reinhart and Rogoff (2008b) and sources cited therein.

FIGURE 3: CUMULATIVE INCREASE IN REAL PUBLIC DEBT IN THE THREE YEARS FOLLOWINGTHE BANKING CRISIS

PERCENT INCREASE

100 150 200 250 300

Malaysia, 1997

Mexico, 1994Japan, 1992

Japan, 1992

Philippines, 1997

Korea, 1997Sweden, 1991

Thailand, 1997

Historical Average

Spain, 1977

Indonesia, 1997

Chile, 1980Finland, 1991

Colombia, 1998

Index=100 in year of crisis

186.3 (an 86 percent increase)

Notes: II ratings range from 0 to a 100, rising with increased creditworthiness.

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)

0 5 10 15

Argentina, 2001

Chile, 1980

Indonesia, 1997Malaysia, 1997

Korea, 1997

Thailand, 1997

Average

Colombia, 1998

Finland, 1991

Japan, 1992

Norway, 1987Sweden, 1991

Hong Kong, 1997Mexico

Default/restructuring

Near-default/bailout

5.1 years-15.1

0-5-10-15-20-25-30-35

PERCENT DECLINE DURATION IN YEARS


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Reinhart and Rogoff (2009b) note, the huge buildups in gov-ernment debt are driven mainly by sharp falloffs in tax rev-enue. The much publicized bank bailout costs are typicallysecond order. Fiscal stimulus also adds to the deficits inadvanced and emerging market economies.4

Downgrades(sometimes default)

A S S H OW N I N F IG UR E 4 (on the previous page), sovereigndefault, debt restructuring, or near defaults (prevented byinternational bailout packages) have been a part of the finan-cial crisis experience in many emerging markets, therefore adecline in the country rating hardly comes as a surprise.

Advanced economies, however, do not go unscathed Finlandsscore went from 79 to 69 in the space of three years, placing itclose to the scores for some of the emerging markets!

Conclusions and implications foremerging economies

A N E XA MI N AT I O N of the aftermath of severe financial crisesshows deep and lasting effects on asset prices, output, andemployment. Unemployment rises and housing price declinesextend out for five and six years, respectively. The recessionsare almost invariably accompanied by massive increases ingovernment debt. The crises adversely impact sovereign cred-itworthiness, as reflected in higher risk premia.

The global nature of the present crisis will make it far moredifficult for many countries to grow their way out throughincreased exports. The growth slowdown is amplified in worldcommodity markets, as many emerging markets face steepdeclines in their terms of trade.

If historical patterns hold, showing alink between banking and debt crisesthe current lull in sovereign defaults orrestructurings in emerging markets willlikely come to an end, particularly if therecovery process in the worlds largesteconomies is delayed.5

With the advanced economies run-ning large government deficits that areaccompanied by a rapid rise in govern-ment debt, emerging markets will findexternal private financing less avail-ablethis is the global dimension of

crowding out. Emerging markets willtherefore rely more on the multilateralinstitutions for external funds and ondomestic debt. It is important for poli-cymakers in these countries to remem-ber that fiscal space is limited, thattheir scope for sustained stimuluspackages financed by debt is capped bytheir low thresholds for debt (at leasthistorically). More than one half of

emerging market sovereign defaults since World War II tookplace at levels of debt below 60 percent and would have satis-fied the Maastricht criteria.6 Debt intolerance applies to bothexternal and domestic debt.

Carmen M. Reinhart is Professor of Economics at the University of

Maryland.

References

Ilzetzki, Ethan, Enrique Mendoza and Carlos Vegh, How big (small) arefiscal multipliers? Mimeograph, University of Maryland. College Park, June

2009.

Reinhart, Carmen M. and Kenneth S. Rogoff , The Aftermath of Financial

Crises, American Economic Review, Vol. 99 No. 2, May 2009a, 466-472.

Reinhart, Carmen M. and Kenneth S. Rogoff , Banking Crises: An Equal

Opportunity Menace, NBER Working Paper 14587, December 2008. CEPR

Working Paper 7131, January 2009b.

Reinhart, Carmen M., Kenneth S. Rogoff and Miguel A. Savastano, Debt

Intolerance, Brookings Papers on Economic Activity, Vol.1 Spring 2003,

1-74

Endnotes

1 The Aftermath of Financial Crises, (with Kenneth S. Rogoff), American

Economic Review, forthcoming, May 2009.http://terpconnect.umd.edu/~creinhar/Papers.html

2 The historical average, which is shaded in black in the diagram, does not

include the ongoing crises.

3 See Calvo, Izquierdo and Loo-Kung (2006).

4 While, historically, stimulus packages have not been as large in emerging

market economies as in advanced economies, fiscal multipliers also appear

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

advanced and developing economies on impact, they erode much more

quickly in emerging markets.

5 Reinhart and Rogoff (2009b).

6 See Reinhart, Rogoff and Savastano (2003).

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D E C E M B E R 2 0 0 9 13

BY HANS-WERNER SINN

T H E C R I S I S O R I G I N A TE D in the United States (U.S.). Sinceabout 1980 thesavings rate of U.S. households had fallenfromabout 10 percent to nearly zero and, because households didnot save, the U.S. had to import gigantic amounts of capitalfrom the rest of the world to finance its investments and gov-ernment budget deficit. Capital imports amounted to 790 bil-lion dollars in 2008. One ofthe reasons for the decline in sav-ings rates was that the U.S. financial system generously pro-

vided mortgages to homeowners, which often was tantamountto hidden consumer credit. The excess of new mortgages overhousing investment approached 60 percent in the yearsbefore the crisis. Homeowners and banks had jointly specu-lated on increasing house prices. On top of that, the govern-ment with its Community Reinvestment Act had forced banksto lend even to the poorer segments of the population.

After the bubble burst

A FT E R T H E B U B B L E B UR ST, house values declined by a thirdby April 2009, which was a decline in wealth in the order of 6trillion dollars. The decline in home values was followed by a

worldwide decline in other asset values of about 50 trilliondollars because of secondary effects. This has sent shock

waves through the U.S. and the rest of the world via three mainchannels. The first and most important channel was the

decline in construction in the U.S., following the decline inthe sale of new homes: 75 percent by April 2009. The second

was a decline in worldwide consumption because of the wealtheffect and the increase in unemployment. The third was acredit crunch resulting from the fact that huge equity losseshad forced banks to scale down their lending and investmentoperations so as to avoid violating the supervisory minimum

SPECIAL REPORT

Shock Producers andShock Absorbers in the Crisis

Would jumbo loans replace the economic void left by the collapse of the subprime mortgage market?


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debt-equity ratios. The U.S. banking system alone had lost 53percent of its equity stock by February 2009.

The shockwaves of the bursting bubblewere then mitigatedthrough extensive bank rescuepackages in the order of 4.1tril-lion euros and Keynesian counter-cyclical budgetary effects inthe order of 1.1 trillion euros. The budgetary effects camethrough discretionary measures as well as through the built-inflexibility of the national tax-expenditure systems. Figure 1showsthe changes in thedeficit/GDP ratiosfrom 2008 to 2009

for the OECD countries and thus measures the respectivecountries Keynesian stimuli to counteract the world recession.

Fiscal stimuli

W H I L E S M A L L E R C O U N T R I E S like Norway, Australia,Sweden, or Denmark areamong the countriesthat have exert-ed theproportionally largest fiscalstimuli, theU.K. is theout-performeramongthe bigcountrieswith a 7.3percentage pointincrease in the deficit share in GDP. On average, the OECDcountries have increased their deficit share by 4.5 points, andthe euro area has increased its own by 3.7 points. At 4.3

points, the U.S. comes close to the OECD average, and at 3.6points Germany comes close to the Euroland average. Amongthe big European countries, France and Italy lag a bit behind

with 3.3 and 2.6 points respectively.In the winter months some international irritation was

caused by U.S. officials and scholars accusing Germany of notproviding sufficient Keynesian stimuli against the crisis. Thedata show that there may have been some foundation for thisallegation. However, the differences are not particularly large.

While it is true, for example, that the U.S. has taken more sub-stantial discretionary measures than Germany, the built-inflexibility of one of the worlds largest welfare states has pro-

vided an automatic stabilization effect that must also be takeninto account. Still, as is shown in Figure 1, the overall U.S. fis-cal stimulus was somewhat bigger.

Trade balances

H O W E V E R , T H I S I S N A T U R A L since the crisis originated inthe U.S. and not in Europe. A more important question for anoverall assessment of the situation is, therefore, how large the

Source: OECD Economic Outlook 85 database; calculations by the Ifo Institute.

FIGURE 1: CHANGES IN GOVERNMENT DEFICIT/GDP SHARES 2008-2009, OECD COUNTRIES, PERCENTAGE POINTS


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SPECIAL REPORT

BY MARTIN RAVALLION

T H E C R I S I S I N T H E D E V E L O PE D W O RL D has spilled overinto the lives of the worlds poorest. Because of the crisis,poverty is higher in most developing countries, although theimpact is greater in some countries than in others, due to dif-ferences in their dependence on foreign trade, investmentand remittances. Differences in pre-crisis savings rates andin the accumulation of foreign reserves also mean that somecountries are facing more severe fiscal adjustment problemsthan others. While some countries have had scope for a fiscalstimulus, others have not.

The effects are certainly not confined to the poorest, and

not all of the poor will be affected. Indeed, some are beingprotected by the same factors that have kept them poorgeo-graphic isolation and poor connectivity with national andglobal markets. However, the poorest can be particularly vul-

nerable even to seemingly small income shocks. For example,productive activity is simply not feasible at low levels of nutri-tion; this threshold effect means that a negative shock ofsufficientsize canpush a poor household past itstipping pointand put it on a path to destitution.

Research has shown that past crises have left lastingeffects. A study of the longer-term impacts of the East Asiacrisis found that about half of Indonesias poverty count in2002 was attributable to the 1998 crisis even though macro-economic recovery had been achieved well before 2002.1

Many of the actions poor families have to take to help protecttheir current living conditions have lasting consequences.Debts rise; key productive assets (such as livestock or land)

are sold. And kids are taken out of school to save money andadd to the familys current earnings.

When poor families are compelled to cut short their chil-drens schooling in response to a shock, this creates a lasting

The Crisis and the Worlds Poorest

A family living under a bridge in Jakarta, Indonesia.


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D E C E M B E R 2 0 0 9 17

impact on poverty since school drop-outs tend to earn less asadults. This impact will vary, depending on the extent of theshock and initial conditions. Declining wages make childlabor relatively less attractive, and schooling more so; but, atthe same time, lower parental incomes increase the value ofthe extra money that children can bring to the family budget ifthey work. The balance of these forces varies from place toplace. There is evidence that in low income countries school-ing tends to decline in a macroeconomic or agro-climatic cri-

sis while in middle- and higher-income countries schoolattendance increases.2 Impacts on the nutritional status of

young children in poor families are also of special concern,since poor nutrition in the early years of life retards childgrowth, cognitive and learning ability, schooling attainmentsand, in all likelihood, earnings in adulthood.

Expected impacts on aggregate poverty

P O V E R T Y C O U N T S R E Q U I R E H O U S E H O L D S U R V E Y S , whichwill not be available for some time. Given these lags, we mustrely for now on projections. Before thecrisis, theincidence ofpoverty in the developing was on a trend decline. The propor-

tion of the developing worlds population living under $1.25 aday in 2005 pricesfellfrom52 percent in 1981to 25 percent in2005; that implies 500 million fewer poor by this standard(from 1.9 billion in 1981 to 1.4 billion in 2005).3

This trend would have almost certainly continued in theabsence of thecrisis. To assessthe impact of thecrisis we needto estimate the difference between the expected level ofpoverty, given the crisis, and what we would have expectedbased on the pre-crisis trajectories.

The poverty impact of the crisis in a given country willdepend on how it affects both average consumption and thedistribution of consumption relative to the mean. The World

Banks Development Prospects Group has made projectionsfor average consumption at the country level after the crisis.These can be compared to theBankspre-crisis projections toassess the expected impact of the crisis. At the time of writing(mid-June 2009), we expect the crisis to knock almost 5 per-centage points off the consumption growth rate for 2009,bringing it down to zero. The effects on growth impacts willtend to be greater in less poor countries. (Eastern Europe andCentral Asia figure prominently in this group). This pattern

will help dampen the overall impact of the crisis on poverty.What about the distributional effects within countries?

Experience suggests that relative inequality falls about asoften as it rises during aggregate economic contractions, with

zero change on average. So the most defensible assumptionfor estimating the effect on aggregate poverty is that the bur-den of the crisis will be more-or-less proportional to initialincome. However, while this is plausible in the aggregate, dis-tributional impacts can be expected in individual countries,

with inequality rising in some and falling in others.Applying country-specific growth projections to survey-

based data and aggregating them, we estimate that the crisiswill increase the 2009 count of people living below $1.25 a dayby 50 million.4 More than half of this increase is expected to

be in South Asia; 10 million will be added to the poverty countin East Asia and 7 million in Sub-Saharan Africa. Another 64million will be added to the number of people living under $2a day. Given the current growth projections for 2010, there

will be a further increase in poverty in that year, with a cumu-lative increase of 89 million people living under $1.25 a dayand 120 million more under $2 a day by 2010.

Of course, aggregate poverty measures cannot tell thewhole story. There will also be impacts on non-income

dimensions of welfare. Colleagues in the Banks researchdepartment estimate that the crisis will lead to 30-50,000excess deaths amongst infants in Sub-Saharan Africa this

year; these will be disproportionately girls.5

Social policy responses6

C R I S I S R E S P O N S E S N E E D T O B A L A N C E short-term reliefagainst the need forrapid recovery. Restoring economic growth

will be crucialto recovery for the worldspoorest. Protecting thepoorest through social assistance need not entail a trade offagainst growth. Indeed, it can be argued that to help restoregrowth, domestic stimulus efforts and external assistance

should favor poor people; and any required fiscal adjustmentsshould minimize negative impacts on the poor. A pro-poorstimulus is likely to be more effective because poor people tendto be more financially constrainednotably due to credit mar-ketfailuresandso are most likelyto engagein rapid consump-tion or investment when extra cash becomes available.

However, experience has been mixed. Crises have givenbirth to some of the worst social protection policies, as wellas some of thebest.Governments have sometimes been drawninto introducing generalized food and fuel subsidies that havecome at a huge fiscal and economic cost, are not easilyreversed, and have had at best modest impact on poverty. Yet

some developing countries have been able to turn a crisis intoan opportunity for dismantling inefficient subsidies in favorof more effective safety-net programs.

Relief work (workfare) is likely to be an important ele-ment of an effective social policy response. But design is cru-cial: a well-designed workfare scheme has built-in featuresthat encourage only those in need of help to seek out the pro-gram and encourage them to drop out of it when help is nolonger needed given better options in therest of theeconomy.

A famous example is the Employment Guarantee Scheme (EGS)in Maharashtra, India, which started in the early 1970s inresponse to the threat of famine. The EGS aims to assureincome support in rural areas by providing unskilled manual

labor at low wages to anyone who wants it. The employmentguarantee is a novel feature of the EGS, which helps supportthe social insurance function, and also helps empower poorpeople. In 2004, India introduced an ambitious national ver-sion of this scheme under the National Rural EmploymentGuarantee Act. This promises to provide up to 100 days ofunskilled manual labor per family per year, at the statutoryminimum wage rate for agricultural labor, to anyone who

wants it in rural India. The scheme was rolled out in phasesand gained national coveragejust in time to help cushion the


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impact of both the crisis and the drought that hit many areasof the country this year.

An ideal workfare scheme will guarantee low wage work oncommunity-initiated projects. The low wage rate ensures thatthe scheme is self-targeted in that the non-poor will rarely

want to participate, and those needing relief during the crisiswill voluntarily leave once recovery is underway. The federalor state government announces that it is willing to finance upto, say, 15 days of work a month on worthwhile community

projects for any adult at a wage rate no higher than the marketrate for unskilled manual labor in a normal year. The work isavailable to any adult at any time, crisis or not. As long as theguarantee is credible it will also help reduce the longer-termcosts of risk facing the poor. Thus a well designed and imple-mented scheme of this sort it can help in fighting chronicpoverty as well as transient poverty in a crisis.

Relief work will need to be supplemented by transfers, incash or food, targeted to specific groups of people who eithercannot work due to physical incapacity, including poor nutri-tional status, or should not be taken out of other activities,notably school. A recently popular class of transfer programsrequires the children of the recipient family to demonstrate

adequate school attendance, and health care in some ver-sions. Early influential examples were Bangladeshs Food-for-Education Program, Mexicos PROGRESA program (now calledOportunidades) and Bolsa Escola in Brazil. Such programs aimto strike a balance between reducing current poverty (throughthe transfers) and reducing future poverty (through thebehavioral responses). In a crisis, the largest benefits fromsuch programs may well be found in the poorest countries,

where the income effect onschooling will probably domi-nate. Targeting the transfersmade as part of a fiscal stimu-

lus to women in poor familiescan also improve the terms ofthe trade-off between currentand future poverty reduction,notably by assuring that chil-dren benefit more.

Experience with such pro-grams suggests that it shouldbe possible to protect a sig-nificant share of the worldspoorest in a crisis. And withcareful policy design, this canbe done without damaging the

longer-term prospects ofescaping poverty, and evenenhancing them.

Martin Ravallion is Director of the

World Banks Research

Department, the Development

Research Group.

These are the views of the author and need not reflect those of the

Bank, affiliated organizations or member countries.

Endnotes

1 See Martin Ravallion and Michael Lokshin, Lasting Impacts of Indonesias

Financial Crisis, Economic Development and Cultural Change 56(1), 2007,

pp. 27-56.

2 See Francisco Ferreira and Norbert Schady, Aggregate Economic Shocks,

Child Schooling and Child Health. Policy Research Working Paper 4701,World Bank, Washington DC., 2008.

3 The average poverty line for the worlds poorest countries is $1.25 a day in

2005 prices at purchasing power parity, while the average line for all devel-

oping countries is $2.00 a day; see Martin Ravallion, Shaohua Chen and

Prem Sangraula, Dollar a Day Revisited, World Bank Economic Review.

23(2), 2009, pp. 163-184.

4 Shaohua Chen and I have used the latest growth projections for 2009 and

2010 (as of mid-June 2009) as the post-crisis growth rates while the

counterfactual (pre-crisis) projections for those done by the Bank in

December 2007 for 2009 and 2010. We have used the growth projections

for private consumption per capita. (Consumption is more appropriate than

GDP for predicting the short-term impacts on poverty, since the shock to

GDP is unlikely to be passed on fully to consumption in the short term.)

See Shaohua Chen and Martin Ravallion, The Impact of the Global

Financial Crisis on the Worlds Poorest, for further detail on the assump-

tions and methods.

5 See Jed Friedman and Norbert Shady, How Many More Infants are Likely

to Die in Africa as a Result of the Global Financial Crisis? Policy Research

Working Paper, World Bank.

6 For a fuller discussion of the issues raised in this section see Martin

Ravallion, Bailing out the Worlds Poorest, Challenge 52( 2), 2009,

pp. 55-80.

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D E C E M B E R 2 0 0 9 19

SPECIAL REPORT

BY VLADIMIR GLIGOROV

C O U N T R I E S I N T R A N S I T I O N in Central, Eastern, and SouthEastern Europe (CESE)have been hit hard by theglobal crisis.Though there was some stabilization at the turn of the first tosecond quarter of this year (2009), therisks of further deteri-oration in some of the countries are still quite high (Gligorov,Poeschl, and Richter 2009).These risks are mainly connected

with the stability of the financial sector, with falling public

revenues, and with slow revival of demand in the EuropeanUnion which is the principal market for CESE exports. Thereis also a need to rethink the growth model because a return to

the status quo ante does not seem realistic, at least not in themedium term.

Integration and contagion

M O S T O F T H E C E S E E C O N O M I E S are small, open, and quiteintegrated withthe EuropeanUnion (EU). These include the socalled New Member States (NMS) that joined the EU in 2004and 2007, two of which have recently entered the euro area

(Slovenia and Slovakia), as well as the countries in SoutheastEurope that have yet to join the EU (so called Future MemberStates, FMS, or candidate and potential candidate countries,

Growth is Disappearing and May Not

Recover in the Medium Run

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which include Turkey). Countries farther to the east, for exam-ple, Ukraine, Belarus, and in particular Russia are either larg-er countries or less integrated with the EU or both.

Integration hasbeen a mechanismof both propagation andmitigation of crisis. Because of the high level of trade integra-tion, the crisis has led to a sharp decline in both exports andimports. In addition,financial integration is a sourceof insta-bility, even though their domestic financial sectors may besound. Thus, countries that are more integrated with the EU

have suffered more from the crisis. On the other hand, thesecountries are also better positioned to profit from the variousmeasures introduced in the EU to support stability and spurrecovery. As long as these measures stimulatetrade and stabi-lize the financial system that has positive consequences forthe more integrated CESE countries because it supports theirexports to the EU markets.

A more fundamental problem of deep integration is that itleads to a strategy of growth that implies high and persistentexternal imbalances: the main indicator being the currentaccount deficit. This could be called a neoclassical growthmodel. In the initial phases, foreign investments rush in toprofit from high productivity growth in capital scarce

economies and, later on, exports increase sufficiently to coverthetrade deficits:in theprocess, there is convergence growth,that is, when growth in less developed countries is faster thanin the more developed ones. The real and nominal exchangerates adjust, basically appreciate, in order to support thatprocess. In the end, the remaining current account deficitreflects the income balance, where the profits and dividendsof the foreign investors are recorded.

Countries in transition can be classified by the stage inwhich they find themselves in this process. Roughly, EUmember states (NMS) have mostly balanced trade by now

(though not the income account), while countries to thesoutheast (FMS) have more pronounced, or very pronounced,trade deficits. Countries farther to the east are less integratedand also depend more on export specializationthey exportmainly oil, gas, metals, and raw materialsand thus have dif-ferent balance of payments structures reflecting a somewhatdifferent model of growth and development.

In the group of countries with current account deficits, thelack of demand for their exports and the declining availability

of foreign financing work together to produce sharp and insome cases disastrous recessions. Negative growth rates varybetween minus almost 20 percent in some of the Baltic coun-tries to minus 1 percent in some Balkan countries (Polandbeing an exception with close to 1 percent growth so far this

year). Overall, more open countries (in terms of the exports toGDP ratio) with trade and incomeaccount deficits, such as theBaltic countries, are doing worse, while more closedeconomies such as Poland, with less of a deficit in theirincome accounts (for example, the FMS), are experiencingmilder recessions. On the other hand, economies that aremore open are better placed to benefit from fiscal and othermeasures that are supportive of trade and may also have more

stable, though not risk-free, financial systems.

Risks and sustainability

E X C H A N G E R A T E R E G I M E S and fiscal policies account formuch of the change in risks and in the assessment of sustain-ability of macroeconomic balances. Given that the main vul-nerability is the external imbalance, the adjustments of theexchange rates have to be expected, as are the limitations onthe activism of fiscal policy, because widening fiscal deficitscan spill over into higher imports.

The risks to the stability of

exchange rates are significant,though the general direction forcountries with current accountdeficits is one of exchange ratedepreciation. However, the distri-bution of risks depends to a largeextent on the exchange rate regime:countries using the euro, those withfixed exchange rates and those withflexible rates have different finan-cial and real consequences.

In general, countries with flexi-ble exchange rates have seen sharp

nominal devaluations, which havealso led to weaker but still signifi-cant real exchange rate devaluations(for example, Poland, the CzechRepublic, Hungary, Romania,Serbia, and Turkey). This has hadsome cushioning effectfor thetrad-able and the real sectors generally,but in certain cases has increasedfinancial risks (for example,

In Budapest, Hungary, construction work has slowed down as a consequence of the financial crisis.


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SPECIAL REPORT

BY BRIAN KAHN

A S T H E G L O B A L C R I S I S U N F O L D E D during 2008, it initiallyappeared as if South Africa, along with other emerging marketeconomies, would be relatively unaffected. South Africasbanking system was only marginally exposed to the subprimeassets that initiated the crisis, and commodity prices acceler-ated during the first half of the year. The U.S. dollar prices ofSouth Africas commodity exports increased by some 26 per-cent between December 2007 and June 2008, while the

domestic equities market reached an historic high in late Mayof that year. Initially the most significant direct impact of theglobal financial markets crisis on domestic markets was a 36percent decline of the financial sector index on the domestic

equities market between November 2007 and July 2008. Thedecoupling hypothesisthat emerging markets in general

were no longer intricately tied to the fortunes of the advancedeconomiesappeared to have some validity.

During 2008 the domestic economy was beginning to showsigns of moderating, after 5 years of growth of some 5 percentor more. Consensus forecasts at thetime indicated that growth

was expected to average around 3.5 percent in 2008 and 2009,before returning to rates of around 5 percent in 2010. Thisslow-down was due in part to emerging electricity supply con-

straints and a tightening of South Africas monetary policystance. The repo rate had been increased by 500 basis pointsbetween July 2006 andJune2008in response to a higher infla-tion trend induced by sustained above-potential growth, real

South Africas Policy May Offsetthe Financial Downturn

COSATU (Confederation of South African Trade Unions) members march through the streets of Durban to protest against food, electricity and fuel hikes.


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D E C E M B E R 2 0 0 9 23

household consumption expenditure growth of around 9 per-cent in 2006, and higher oil and food prices. The higherexpenditure brought about a wideningof the deficit on the cur-rent account of the balance of payments which had reached alevel in excess in 7 percent of GDP in 2007 and 2008. Thesedeficits were financed primarily through portfolio capitalinflows.A prudent and conservativefiscal policy was also beingimplemented, and in the 2008 budget, modest surpluses werebudgeted for the next three fiscal years. The public sector bor-

rowing requirement was projected to increase from a smallsurplus to a deficit of 1.4 percent of GDP in 2010/11.

The situation and outlook changed dramatically afterSeptember 2008 in the wake of the demise of LehmanBrothers. The collapse of global confidence led to a flight ofcapital from emerging markets, a dramatic decline in com-modity prices, and plummeting demand for exports fromemerging markets. South Africa was not spared. Its relativelydiversified export market and product base were insufficientto shield the economy from the fall-out of this synchronizedglobal downturn.

The effect was quickly felt in the financial markets. Fromits peak in May 2008, the domestic equities markets lost 36

percent in value by the end of the year, and 22 percent frommid-September. Thecommodity price index of South Africasexports declined by over 30 percent by October compared

with its June levels, although the terms-of-trade blow wascushioned to some extent by thefall in international oil pricesand the resilient gold price. Portfolio capital flows turnedsharply negative in the fourth quarter of 2008, although theoverall financial account remained positive, partly as a resultof repatriation of foreign currency balances held abroad bydomestic banks. Not surprisingly, these developments had animpact on the rand exchange rate which became highly

volatile and depreciated from a level of around R8.00 against

the U.S.dollar in September 2008 to a low ofaround R11.80inNovember. However by December it had settled down at alevel of around R10 to the U.S. dollar. Because of the limitedexposure of theeconomy to foreign debt, balance sheet effectsof these currency movements were relatively limited.

These developments were reflected in the sudden andsharp downturn in the domestic real economy. Having grownat quarter-on-quarter seasonally adjusted and annualizedrates of 5.0 percent and 0.2 percent in the second and thirdquarters of 2008 respectively, the economy contracted by 1.8percent in the fourth quarter of that year, and by 6.4 percentin the first quarter of 2009. The mining and manufacturingsectors of the economy were particularly hard hit: the manu-

facturing sector recorded negative annualized growth of 22percent in both the fourth quarter of 2008 and the first quar-ter of 2009, while the mining sector recorded growth rates of0.4 percent and -33 percent in these quarters. In the secondquarter of 2009 the economy contracted at a rate of3 per cent,

with the manufacturing sector recording a contraction of 11per cent. The mining sector experienced a turnaround, with agrowth rate of 5.5 per cent. Nevertheless the South Africaneconomy appears to be lagging behind the recovery in a num-ber of the advanced economies. The effects on employment

were felt in the first quarter of 2009 when 179,000 jobs werelost in the formal nonagricultural sector. Exports of bothmanufactured goods and primary commodities declinedsharply. In the first quarter of 2009, total export values haddeclined by 21 percent compared to the previous quarter.

Fortunately, effective regulation and bank supervisionshieldedSouth African banks fromdirect exposureto the trou-bled securitized debt market in the U.S., and they remained

well capitalized. Furthermore, South African banks are pre-

dominantly funded by domestic deposits and not through for-eign-held structured products. Consequently, unlike manyother central banks, the South African Reserve Bank did not atany time have to respond by injecting additional liquidity intothe domestic money market. The domestic interbank marketcontinued to operate smoothly with no anomalies observed ineither the volumes or rates of interbank funding.

However, some deterioration in asset quality was observedin the course of 2008, which was probably attributable to themonetary policy tightening of the previous period. Butimpairments increasedsignificantly as the economy contract-ed. Although there is adequate provision for impaired loans,banks have reacted to the downturn in a pro-cyclical manner

by significantly tightening credit criteria to both householdsand the corporate sector, thereby exacerbating the downturn.Credit markets have therefore been affected by a reduction inboth the supply of and demand for credit. Credit extension tothe private sector, which was growing at rates of around 28percent in January 2008, had declined to rates of around 4percent in June 2009. Overall this represents a decline in realcredit extension, although a number of components of creditextension became negative in nominal terms as well.

The official policy response was to allow for greater flexibil-ity in the application of monetary and fiscal policies. InDecember 2008, the Monetary Policy Committee (MPC) of the

South African Reserve Bank reduced the repurchase rate by 50basis points to 11.5 percent. In February the frequency of MPCmeetings wasincreased to monthly, to allow for a more contin-uous assessment of the rapidly changing situation. The reporate was reduced further by 100 basis points at the Februarymeeting and at each of the subsequent three meetings. Themonetarypolicy stance was unchanged at the Junemeeting, butat theAugust meeting the repo rate wasreduced by a further 50basis points, bringing the total reduction to 500 basis points.

These actions were taken even though inflation, whichmeasured 10.3 percent in December 2008, was well above thetarget range of 3-6 percent. However, the forecasts were forinflation to decline markedly over thenext few months, and to

return to within the target range by 2010. By July 2009, theinflation rate had declined to 6.9 percent. The MPC main-tained a focus on inflation in a forward-looking flexible infla-tion-targeting framework: although inflation was outside thetargetthe committee wassatisfied that it would returnto with-in the target range over a reasonable time horizon. In addi-tion, thewideningoutput gap wasseen to impart a high degreeof downside risk to the inflation outlook.

Nevertheless there were a number of upside risks to theinflation outlook that constrained the monetary policy


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response. Some of the emerging upside risks included highnominal and real wage demands and settlements, a turn-around in the international oil price, stubbornly high foodprice inflation despite a significant decline in agriculturalcommodity prices, and high rates of increases in adminis-tered prices. These factors also contributed to deterioratinginflation expectations.

The monetary policy stimulus was complemented by a con-tracyclical fiscal policy. South Africa was in the fortunate posi-

tion of having sufficient fiscal spacea result of past prudenceto use fiscal policy in a manner that would not raise questionsabout sustainability. It is generally agreed that fiscal stimuli insuch circumstances should be reversible, with an emphasis onincreasing growth-enhancing capital expenditure. The prob-lem is that capital expenditure takes time to implement and somay not be well-suited for cyclical purposes. It was thereforefortuitous that government had embarked on a large-scaleinfrastructure expenditure program during the earlier part ofthe decade (including road and rail infrastructure, telecom-munications, and more recently electricity generation), andmuch of this was coming to fruition at a time when most need-ed from a cyclical perspective. Government and state-owned

enterprise expenditure on infrastructure is expectedto average9.7 percent of GDPover the next three yearscompared with 4.5percent of GDP in 2005/06. The public sector borrowingrequirement is now expected to increase to 7.5 percent of GDPin 2009/10 before moderating to 5.3 percentby 2011/12. Thesedemands on the capital markets are sustainable because gov-ernment debt to GDP is currently a modest 22 percent.

There was also directstimulus through the budget. The gov-ernment had budgeted for a surplus of 0.6 percent for the2008/09 fiscal year, and with declining tax receipts the out-come was a deficit of 1.2 percent. As a result of the slowingeconomy and a discretionary fiscal stimulus, a deficit of 3.9

percent of GDP was budgeted for the 2009/10 fiscal year. It isestimated that about half of this increase was due to lowerexpected tax receipts, implying an expenditure stimulus ofsome 2 percent of GDP. More recently the minister of financenoted that tax revenues are likely to be somewhat lower thananticipated,and a higher deficit outcome is likely. Howeverthegovernment has projected deficits for the next two financial

years to decline to 3.1 and 2.3 percent of GDP respectively.South Africa has not been spared from the impact of the

global crisis. However its policy response should to someextent help to contain the contraction. Some internal andexternal developments indicate that the worst may be over.Portfolio capital inflows have resumed; the rand has appreci-

ated to almostpre-crisis levels; commodity priceshave recov-ered from their lows, although still significantly below theirhighs of last year; and most leading indicators show that pos-itive growth should be achieved during the latter part of this

year. Nevertheless the recovery is likely to be slow and hesi-tant, and dependent to a significant degree on the nature andspeed of the global recovery.

Brian Kahn is Head of Research and Policy Development at the South

African Reserve Bank.

level of integration and interconnectedness of the financialsystem in the EU and in the transition countries would makesuch a crisis even more devastating then thecurrent one. Thisis whythe International Monetary Fund (IMF) hasbeen calledback to support globalfinancial stabilityto bail out thebanks

in effect. It can be expected that many countries in transitionwill end up with stand-by agreement before this crisis is over.In addition, the IMF is supporting the so-called ViennaInitiative, which is a commitment by the banks in countriesthat have an IMF program to keep their credit exposure atexisting levels, which should help the process of orderlydeleveraging. However, in the event of mishaps, financialfailure would be transmitted through the interconnectedbanking system quite quickly (Arvai, Driessen, and Otker-Robe 2009).

The other risk is that these economies may experiencestagnation in the medium run. That will have serious conse-quences for labor markets. Employment will decline anyway

and slow growth will accentuate the already existing structur-al imbalances in these markets (high unemployment, signifi-cant segmentation, low employment), possibly leading tosocial problems and to growing populism. There is little thattheEU can do to address that eventuality,shortof engineeringa strong recovery with strong import demand, which is notsomething that is being forecasted at the moment.

Conclusion

T H E N E O C L A S S I C A L M O D E L O F G R O W T H in the CESE hasbeen disrupted by the current crisis and it is not certain that it

can be revived in the medium run. In addition, there are stillsignificant risks that crisis may become even worse, especial-ly if theprocess of deleveraging does not proceed in an order-ly manner. Switching to the alternative growth model basedon higher domestic savings would be difficult and woulddepend on the recovery of EU demand for exports from coun-tries in transition. If that does not happen either, the returnto convergence growth rates may prove problematic in themedium run.

Vladimir Gligorov is Senior Researcher at The Vienna Institute for

International Economic Studies.

ReferencesArvai, Zsofia, Kar

development outreach: december 2009 - growing out of crisis

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