The Global Financial Crisis and Development Strategy for Emerging Market Economies

The global financial crisis of 2008-09 is a watershed event that cries out for a reexamination not only of industrial countries' financial systems but also of growth strategies in developing countries. I will argue that the worst of the crisis is over, and that the developing countries are emerging with less damage than in the debt crisis of the 1980s, for Latin America, and the financial crisis of the late 1990s, for East Asia. Nonetheless, serious fiscal challenges will confront the industrial countries in the coming years, as a consequence of bailout costs and recessionary fiscal losses. Moreover, several key emerging market economies will need to reorient their growth strategies away from mercantilist trade surpluses toward production for domestic demand and greater expansion of balanced trade among themselves. Why should one think that the worst of the crisis is behind us? This crisis was the first of the postwar period to be caused by a near-collapse of the banking system in the advanced economies. The aggressive measures taken by the Federal Reserve, Treasury, and FDIC have stabilized the US banking system. The great anxiety that the main banks would have to be nationalized has now passed. Confidence has been revived by the stress test exercise that greatly increased transparency and demonstrated that it would require even worse loss rates than in the great depression to cause severe jeopardy to the banks' capital position. Several major banks have now repaid the Troubled Asset Relief Program (TARP) money, and if the other key banks need more capital, they will simply become somewhat more nationalized as they sell more shares to the government, rather than collapsing. Some worry that European banks are in severe danger, and cite the International Monetary Fund (IMF) estimates of larger credit losses ahead ($750 billion) than for the US banks ($550 billion). But those losses would be against a much larger asset base in the eurozone ($34 trillion in bank assets) than in the United States ($11 trillion). So it is unlikely that European banks in general are in worse shape, although those that are disproportionately exposed to Central Europe may be. If the heart of the crisis was the shock to the banking system, then overcoming that shock should mean that the worst part of the crisis has been overcome. The forecasts do indeed show moderate recovery next year from this worst recession since the Great Depression. Based on IMF and private sector forecasts, industrial countries' output will fall nearly 4 percent this year, but be back to positive growth of 1 percent next year (figure 1). Emerging Asia will do the best, returning to 6 percent growth next year after keeping positive growth of nearly 4 percent this year. Latin America, Eastern Europe, the Middle East, and South Africa should return to about 2 percent growth next year after sharp declines this year (especially in Europe). The overall pattern is that this global recession is

2 worse than the one in 1982 for industrial countries (especially Japan, where output will fall 7 percent this year), but not as severe for Latin America, nor as severe as the late 1990s crisis for East Asia. The forecasts are counting on a sharp reversal of severe setbacks in late 2008 and early 2009. In the main industrial countries, industrial production in the first quarter was about 20 percent below a year earlier (figure 2). Given the tight interconnection in international production chains, there was a corresponding collapse in exports of both industrial and emerging market economies. The plunge in exports for countries such as China and Singapore is evidence that the main problem has been foreign demand, not lack of export finance (given their massive reserves). Nonetheless, markets are signaling that the worst is over for emerging markets. Risk spreads on the JP Morgan EMBI+ index surged from 200 basis points at the end of 2007 to 750 basis points at the height of the crisis, but are now back to 450 basis points (figure 3). This level is moderate compared to the far higher ranges in the crises of the late 1990s and the Argentina-Brazil crises of 2001-02. Moreover, because US long- term Treasury base rates are far lower than in the earlier periods, the actual level of the emerging market sovereign interest rates are lower than might be inferred from the spreads. Indeed, this time the crisis has mainly been for corporates rather than sovereigns, download.