The Global Financial Crisis and Developing Countries

Valpy FitzGerald

Oxford Department of International Development

UNDP HDR Course, St Catherine’s College, Oxford

22 September 2008

Three FAQs1. What is happening on global

financial markets?

2. What does it mean for developing countries?

3. What can be done from a human development perspective?

FAQ 1

What is happening on global financial markets?

Origins of current financial crisis• Since 1990s deregulation of financial markets: risk

pricing replaces prudential supervision. Rise of derivative “assets” with opaque markets and few players. Bank loans replaced by bonds etc.

• Huge US fiscal deficit, monetary expansion (“Greenspan put”), low savings led to a US mortgage boom/bust (non traded sector) and a huge current account deficit (traded sector).

• Mortgage bubbles (e.g. 1992 in UK) are familiar with obvious political costs; join recurrent bubbles in past decade (dotcoms, LTCM, Tequila etc);

• But this is by far the most serious systemically because it threatens the global banking system itself as creditor, and whole US electorate as debtor.

“the elephant in the room”

Sub-prime lending• Sub-prime lending had spread from inner-city

areas right across the US by 2005. By then, one in five mortgages were sub-prime, and they were particularly popular among recent immigrants trying to buy a home for the first time, and the poor.

• House prices were high, and it was difficult to become an owner-occupier. But these mortgages had a much higher rate of repossession than conventional mortgages (and thus much riskier) because they were adjustable rate mortgages (ARMs). Payments were fixed for two years, and then became higher and linked to Fed interest rates, which also rose substantially.

Subprime 2

• A wave of repossessions is sweeping America as many of these mortgages reset to higher rates. By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting for of bondholders, was the largest property owner in the city.

• As many as two million families will be evicted from their homes as their cases make their way through the courts. The Bush administration is pushing the industry to renegotiate, but mortgage companies are being overwhelmed by a tidal wave of cases.

Scale and Spread• Collapse of the government backed

mortgage system in the USA (Fannie and Freddie) followed by meltdown of major investment banks (Lehman, Bear, Merrill) exposed to mortgage market

• Mark-to-market asset pricing effects on balance sheets and cumulative liquidity retraction due to rising risk aversion;

• Now affecting Insurance (AIG) ; and pensions funds next?

Global mortgage boom and bust

The end of the stock market boom

Financial Times, 20 Sept 2008 • “…bank boards and bank executives have

failed to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.”

• “…a reward system that has granted huge bonuses to those who peddled toxic mortgage-related products….”

• “Almost as absurd has been the degree of leverage racked up by investment banks.”

Policy reactions• “There are no atheists in foxholes and no

ideologues in financial crises,” Mr. Bernanke told colleagues…(NYT 21.09.08)

• Freddie Mae and Freddie Mac (re)nationalised; Merrill sold to BankAmerica; Lehman to Barclays; Goldman and Morgan become banks again; US govt $700bn purchase of bad debt; G3 central banks support world banking.

• Expansionary monetary policy (to avoid recession like 1930s) and scale of US Govt (and G3) bailouts will have large repercussions, yet to be evaluated [lessons of Mexico etc?]

Scale of the potential bailout (already up to $850bn)

FAQ 2

What does it mean for developing countries?

Growth and trade

• World GDP growth already projected by IMF to slow down by 2 % points (from 5 to 3 for 2008 and 09); probably more. So with 2% world growth; global GDP per capita falls

• Asia probably most resilient (though exports to US will fall); LA will slow down, Africa recession?

• Commodity prices declining already; volumes too. Natural resource exporters will be hit; food and oil importers to benefit.

World growth will slow, reducing trade expansion etc.

An end to the commodity boom?

Investment and aid

• International investment (bonds, FDI) will slow down; as will emerging market stocks; as global confidence declines

• Sovereign spreads will rise due to rising risk premium (default probability x risk aversion): already up to 4%.

• Aid flows already under pressure; will be hurt by fiscal overload in G3.

S&P 500 vs Emerging Markets Index

Unsurprisingly, G3 market expectations are bad

US now HIRC?

Recent ODA rise will be difficult to sustain

Poverty and human development

• MDG goals even less likely to be met (growth and aid are main drivers)

• Limitations of family support (Asia), few universal benefits (LA) and narrow safety nets (Africa): effect on poor

• Previous crises increased inequality, which remains even when growth recovers

• Commodity price reverse will change lottery of winners and losers

FAQ 3

What can be done from a human development

perspective?

Proactive macroeconomic policy

• Countercyclical monetary policy and real exchange rate management (inc. capital controls) necessary: – MICs with forex reserves already do this;– but LICs constrained by IMF.

• Support domestic banks (esp for agriculture and SMEs), underwrite longterm investment lending; keep real interest rates low.

• Raise tax pressure (not rates) to maintain fiscal balance and reduce public borrowing.

HD strategy for difficult times

• Evidence (UNICEF) that for children employment stability more important than wages; implications for e.g. inflation policy

• Essential to ringfence budgets (in real terms) for education and health; extend schemes for (simple) universal benefits.

• Focus on inequality (especially horizontal) rather than just poverty; to reduce conflict and increase social cohesion.

International action and the “duty to protect”

• Essential to moderate G8 policy shifts (e.g. bank regulation, interest rates, exchange rates) from viewpoint of impact on world poor.

• Need for UN to speak in a clear, timely and credible fashion on these issues (TDR08 good, UN/DESA etc silent)

• Regional arrangements for mutual currency support etc are vital (Asia progressing; LA talking; Africa nothing). Role for sovereign wealth funds?