How developing countries will be hurt by the Western crisis

Martin Khor

As the financial chaos and crisis continue to unfold in the United States and Europe, with new shocks and policy responses each day, it has become clear that the developed countries are sinking into recession.

This has already begun to affect the developing countries. And the effects will worsen as both the financial crisis and the recession impact in various ways on different developing countries.

In an interview with SUNS, the former director of UNCTAD's Division on Globalisation and Development Strategies Division, Dr. Yilmaz Akyuz, gave his views on the current crisis in the developed countries and the mechanisms by which aspects of the crisis are being or will be transmitted to developing countries.

According to Akyuz, the crisis is a part of the recent series of boom and bust financial crises. However, what form a particular crisis takes will differ from other crises. This crisis is different from the United States' S&L (Savings and Loans) crisis (which was caused by regulatory loopholes) or the dot.com crisis (which was caused by the stock market bubble).

The present crisis is a banking crisis. According to Akyuz, the financial deregulation from the 1980s broke down the limits to how much non-traditional activities the commercial banks can be involved in. For example, in 1992 the US passed a law that increasingly allowed commercial banks to be involved in securities activities.

This was in line with what had become the prevailing thinking, but a few officials such as a former New York Reserve Bank chief warned that the firewall between commercial banking and investment banking activities should not be demolished. While the US and UK allowed their commercial banks to originate securities, and to sell and buy them, Germany did not prevent its commercial banks from buying the new types of securities, although they did not originate them.

There developed an inherent tendency of excessive risk taking, said Akyuz. Having banking regulations such as a 10 per cent capital requirement for banks is not enough when markets can go up and down by 10 per cent a day.

Having direct restrictions should now be considered, according to Akyuz. For example, banks should not have so much leverage, there should be restrictions on their involvement in securities activity, and on their lending to brokers.

On the present action by several Governments to nationalise troubled banks, Akyuz was critical of the negative way in which State-owned banks have until recently been usually viewed.

The public had been told that State-owned banks are inefficient and cause crises, and thus there should be liberalisation. But now there is a much bigger crisis after banks had been privatised and deregulated. And, ironically, the State is now again involved in banking when things went wrong.

The effect of the financial crisis on the real economy has not been really seen yet. It should not be forgotten that the crisis is not so much about finance but about people, jobs and income. We haven't seen even the beginning of this crisis yet, said Akyuz. When the real-economy crisis hits, there may be no one to borrow and spend, even when later the banks may start lending again, he warned.

Akyuz sees two lags in period during this crisis - firstly the lag of impact, or the time before the financial crisis is transmitted to the real economy, and secondly the statistical lag, or the time between the impact and when the impact is accurately reported in data.

For example, official data so far do not show a decline in US national income. Akyuz calls this a 'mystery' as there is a significant discrepancy between signs of recession being already present in the US and the official statistics that show real growth has continued.

There is also a lag period in transmission of the Western-based crisis to developing countries. But the effects will be felt in various ways.

In his paper for the ESCAP Ministerial segment in April, on the global financial turmoil and Asian developing countries, Akyuz gave an analysis of two mechanisms by which this transmission will take place - the finance route (for example via capital flows, the capital account in the balance of payments and exchange rates) and the trade route (the effects of Western recession on developing-country exports).

Elaborating and updating his analysis on the ways in which developing countries will be affected, Akyuz said that there will likely be a 'flight to quality' by international capital, affecting developing countries in various ways.

Firstly, there is an exit of portfolio capital from stock markets in developing countries towards safe assets such as US Treasury bonds. Secondly, as investors and creditors are very reluctant to lend as the perceived risk is very high, there will be a high premium on interest rates charged on loans to developing countries, raising the cost of borrowing in these countries. Akyuz also predicted that there may be a significant increase in exchange-rate instability, a lot more than what is seen now in developing countries.

For example, there will be a lot of upward pressure on the Chinese yuan, while other Asian currencies depreciate, a trend that is taking place now already. This is leading to a 'de-coupling' of intra-Asian exchange rates. The extent to which developing countries are directly affected by the financial crisis depends significantly on how much of the 'toxic' bonds and securities originating from the US or Europe that they are holding.

According to Akyuz, US official data show that Central Banks outside the US hold $1 trillion of agency debt (for example, by the two US giant mortgage agencies that have been taken over by the Government), and some of the central banks may be from developing countries.

However, there is no data available on how much of these troubled securities are being held by private banks, insurance companies or other companies that are from outside the United States. The scale of the problem for private institutions in developing countries is thus not known.

The crisis will also hit developing countries through the trade route. Akyuz noted that there is already a significant drop in the prices of oil and other commodities exported by developing countries, which is affecting their export earnings and their trade balance. Worse will come on this front.

Akyuz does not expect a V-shaped sharp-fall and sharp-recovery cycle in the US and Europe, but a long period of slow growth, as what Japan went through in the 1990s. This lengthy period of stagnation will especially hit commodity exporting countries, especially in Africa, Latin America and South-east Asia.

Their exports to the developed countries undergoing recession will be hit directly. But their exports to other countries such as China will also be hit, as the Western countries reduce their demand for China's products, which in turn will reduce China's demand for commodities and other products.

- Third World Network Features