The Fallout from the Crisis: Perspectives for Development Finance

The Fallout from the Credit Crisis: Perspectives for Development Finance Fourth Meeting of ACP Ministers of Finance and Economic Affairs Andrew Mold, Brussels Senior Economist 12-13th November 2008 OECD Development Centre

Introduction – Observations from some eminent economists • “To some of us, the financial market turmoil that started in the summer of 2007 reflects the secular transformation of the global economy. There are now economic and financial forces in play whose impacts are of great consequence but that cannot as yet be adequately sustained by the world’s current policy and market infrastructures.” Mohamed El-Erian (2008.4) • “...the conclusion is unmistakable that financial failure has been more extensive and pervasive in the last thirty years than in any previous period.” (Kindleberger and Aliber, 2005:6) • “In the past, major crises in developing countries usually had a regional concentration.... But the epicenter of the current crisis lies deep inside the developed economies, and therefore we would expect all developing regions to be damaged by the shocks.” (Justin Lin, 2008: 11) OECD Development Centre 2

Outline – Some key issues…. • Current account considerations • Capital account considerations, especially - Foreign Direct Investment - Development aid • Econometric work to underpin findings • Policy issues arising (every cloud has a silver lining?)‫‏‬ – International Financial Architecture – The policy reaction so far – A final cautionary note on economic forecasting OECD Development Centre 3

Current account considerations (1) Current Account Balances – 1980-2008 as % of GDP Developing Countries Sub-Saharan Africa Source: IMF WEO October 2008 4 OECD Development Centre

Current account considerations (2) Current Account Balances – 1980-2008 as % of GDP Western Hemisphere Central Asia and Eastern Europe Source: IMF WEO October 2008 5 OECD Development Centre

Current account considerations (3) Is the era of high commodity prices over? • Prior to crisis (and esp. the first 12 months after), commodities seen as an “alternative asset” by hedge funds and other investors: – Low or negative correlations with other major assets – the fact that near futures prices and spot prices converge provide a prima facie case that financial inv. increases prices. • “Crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses.” (Reinhart and Rogoff, 2008). • Historical evidence? Favourable TOT (high prices for primary commodities) → ↑ borrowing → collapses into defaults when prices drop. 6 OECD Development Centre

Current account considerations (4) Commodity Prices and New External Default 1800-1939 1940-2006 Source: Reinhart and Rogoff (2008)‫‏‬ OECD Development Centre 7

Current account considerations (5)‫‏‬ 1940- 2007 Source: Reinhart and Rogoff (2008)‫‏‬ OECD Development Centre 8

Current account considerations (6) Is the era of high commodity prices over? (2)‫‏‬ Only weak evidence of causality between financial positions and commodity prices (IMF GFSR, 2008)‫ ‏‬but view is controversial. , Test of causality between commodity prices and Financial Position (IMF, GFSR, 2008.‫‏‬ ) 9 OECD Development Centre

Current account considerations (7) The Cost of Fuel and Food Subsidies as a % of GDP, 2008 Source: IMF WEO October 2008, page 103 OECD Development Centre10

Current account considerations (8) Commodities Prices for LDCs – Some Caveats... – The surge in food prices transmitted in varying degrees from international to local markets. E.g., in Tanzania, 81% in ↑ international maize prices 2003-2008 captured in local prices. – In Ghana and the Philippines local rice prices have adjusted to around 50% of the world price change. – Prices of tea, tobacco and cotton lower in 2006 than in 2000 (even nominally). Coffee (both Arabicas and Robustas) higher, but still lower than in 1995 (UNCTAD, 2008:16). – Coffee prices in October suffered a 23% drop in Rwanda, causing significant hardship to producers 11 OECD Development Centre

Current account considerations (9) Wholesale Maize prices in selected Eastern Africa markets Source: FAO, Crop Prospects and Food Situation, October 2008 OECD Development Centre 12

Current account considerations (10) • International Trade.... • How vulnerable are countries through trade? – Exports increased from 29 per cent in 2000 to 39 per cent in 2007 as a share of developing countries‟ GDP. – Credit-lines on trade are drying up: a serious predicament for many exporters. – US and EU generate 54% of world GDP, at market prices.+ Japan, 62% of GDP. – US alone imports 16 % of world commodities. 13 OECD Development Centre

Current account considerations (11) Source: Minella (2008)‫‏‬ Source: Carrera (2008)‫‏‬ OECD Development Centre 14

Current account considerations (12) Source: UNCTAD LDC Report, p. 158 OECD Development Centre 15

Disturbances through exchange rate volatility • Floating exchange rates since the 1980s – highly unstable – misalignment • Sharp fluctuations in the exchange rate already causing difficulties in some dev. countries (e.g. Brazil, South Africa)‫‏‬ • Knock-on impact of commodity price falls, e.g. copper prices → Zambia‟s currency ↓24% against the dollar since August • Carry trade unwinding 16 OECD Development Centre

Capital account considerations (1) • Poorest countries still highly dependent upon foreign savings – 15 LDCs had negative domestic savings rates in 2006 • E.g. Afghanistan, Burundi, Malawi, Liberia, and Sierra Leone • Only one third of LDCs had gross domestic savings rates above 15 percent • Dependence on external finance – Aggregate net resource flows (% of GDP)‫‏‬ • 11-12 per cent for African and island LDCs • 3 per cent in other developing countries 17 OECD Development Centre

Capital account considerations (2) Aggregate net foreign resource flows to LDCs and ODCs, 2000-06 Source: UNCTAD LDC REPORT (2008:25)‫‏‬ 18 OECD Development Centre

Capital account considerations (3) Rising cost of Capital for the developing world….. 19 OECD Development Centre

Capital account considerations (4) On Portfolio equity flows – sharp decline expected…. Source: Datastream Thompson, 2008 OECD Development Centre 20

Capital account considerations (5) – The importance of FDI..... Net flows in billions US$ to Latin Net flows in billions US$ to SSA, America, 1999-2007 1999-2007 Source: World Bank, Global Development Finance, 2008 OECD Development Centre 21

On FDI (1)‫‏‬ Regression results of FDI forecasting model Source: World Bank, Global Development Finance, 2004 OECD Development Centre 22

On FDI (2) – Is FDI Better? – ↓Vulnerability to external financing difficulties when the CA deficit is financed by FDI inflows (GDF, 2008: 68)‫‏‬ . – BUT - FDI moves pro-cyclically and can intensify instability • M&A activity is about 30-35 % of current flows. – Use of derivative products by MNEs (currency forwards and options) as investment hedge ↑ pressure on domestic currency (Stiglitz et. al, 2006:179). – FDI outflows risen significantly in Hungary, Poland, and South Africa. 23 OECD Development Centre

On FDI (3) – Is FDI Better? • Equity component more stable during crisis, but intra-company loans and reinvested earnings not. • “In most sectors, TNCs have ample liquidity to finance their investments, as shown by the high corporate profits reported, at least until 2007. In the UNCTAD 2008 survey of large TNCs, about one third of respondents envisaged negative impacts on FDI flows in the short term, but about half of them suggested no impacts” (WIR, 2008)‫‏‬ . • Some „opportunistic‟ „fire-sale‟ FDI? Consolidation in banking sector. E.g. Brazil‟s banks - merger of Itaú and Unibanco – creation of largest bank in South America. 24 OECD Development Centre

On FDI (3) Source: FT (2008) 25 OECD Development Centre

On FDI (4)‫‏‬ GDP growth and FDI outflows from US Outward FDI and GDP growth 1st OECD countries, 1970-2007 Qtr 1995 – 2nd Qtr 2008 (4-period moving average)‫‏‬ Source: World Bank, Global Development Finance, 2008 OECD Development Centre 26

On FDI (5) FDI to Low Income Countries and Correlation between FDI outflows Profit Remittances and GDP Growth for OECD countries, 1970-2007 60 40 20 0 -20 -40 0 2 4 6 GDP growth FDI Fitted values Source: World Bank, Global Development Finance, 2008 OECD Development Centre 27

Financial contagion – Stock markets (1) Source: Minella (2008)‫‏‬ 28 OECD Development Centre

Financial contagion - Stock markets (2) Source: World Development Indicators (2008)‫‏‬ OECD Development Centre 29

Development aid (1) • Will „scaling up‟ be put on hold? • OECD 'aid pledge' – we should not add to the financial crisis an 'aid crisis'. • In real terms, ODA in 2007 15% ↑ than the 2004 Gleneagles base year, but compared to the 60% ↑ by 2010 to meet the Gleneagles commitments (DCD/DAC, 2008). • Like FDI (to some extent), aid is highly geographically concentrated. In 2006, Afghanistan, DRC and Sudan accounted for 1/4 of total net ODA disbursements going to the LDC (UNCTAD LDC Report, 2008:27). 30 OECD Development Centre

Recent trends in ODA OECD Development Centre

Development aid (2) Will budgets be hit? In Finland during its banking crisis between 1990-93, when GDP fell by nearly 11 per cent, development aid fell by 60 percent (Roodman, 2008). Can this experience be generalized? 32 OECD Development Centre

Development aid (3) • No unambiguous relationship between economic growth in donor countries and subsequent aid flows (e.g. Round and Odedokun, 2004)‫‏‬ . • Under pressure to reduce expenditures, aid flows are one of the first areas to be affected by cuts? Aid flows tend to be quite resilient to mild recessions (e.g., Bertoli et al., 2008). • Aid is a very small share of budgets, and vis-a-vis rescue packages of domestic financial sector, very small (US$ 3 trillion already?). • The best insurance against cutbacks in aid is to insure that policies are adopted in OECD donor countries to avoid a deep slump. 33 OECD Development Centre

Development aid (4) Source: OECD (2008) and World Bank (2008)‫‏‬ OECD Development Centre 34

Some important econometric work to underpin findings… • Izquierdo, Romero and Talvi (2007)‫‏‬ – LA-7 panel analysis . Concludes that without favourable extenral conditions (improved terms of trade, high global growth, and cheaper financing) growth would have been almost 2 percentage points less than the observed growth rate • Akin and Khose (2008) Panel analysis of 106 countries over the period 1960–2005. distinction between industrialised economies and 2 groups of dev countries, Emerging South and Developing South, based on extent of their integration into the global economy. - the impact of the Northern economic activity on the Emerging South has declined during the globalization period (1986–2005). - in contrast, the growth linkages between the North and Developing South have been stable over time. Thus may be more heavily affected by recession in North. • IMF (2008)‫‏‬ – Analysis of national and international determinants of stock market performance in Latin America, Asia, and EMEA indicates stronger spillover effects for Latin America • Cull and Peria (2007) Using data on the share of banking sector assets held by foreign banks in over 100 developing countries during 1995-2002, authors find that countries experiencing banking crisis tend to have higher foreign bank participation than those that did not 35 OECD Development Centre

Some important econometric work to underpin findings… (2)‫‏‬ Share of banking assets held by foreign banks with majority ownership, 2006 Country 0% - 10% Country 30% - 50% Country 50% - 70% Country 70% - 100% India 5 Senegal 48 Rwanda 70 Madagascar 100 Nigeria 5 Congo, DR 47 Côte d'Ivoire 66 Mozambique 100 South Africa 0 Kenya 41 Tanzania 66 Peru 95 China 0 Bolivia 38 Ghana 65 Mexico 82 Bangladesh 0 Burkina Faso 65 Uganda 80 Ethiopia 0 Niger 59 El Salvador 78 Mali 57 Botswana 77 Zimbabwe 51 Modified from World Bank, Global Development Finance (2008)‫‏‬ OECD Development Centre 36

Policy issues arising from the crisis – Measures taken recently..... 1. Fed cut interest rates to 1% on 5th Nov. 2.International currency swap facility by Fed up to US$30 bln for Brazil, Mexico, Korea and Singapore. 3. IMF announced 29th October a new short-term liquidity facility for 'sound' emerging economies (without usual conditionality)‫‏‬ But do the IFIs have enough resources? e.g. IMF has only $US200 bln easily available. OECD Development Centre

Every cloud has a silver lining? (1)‫‏‬ •China's fiscal stimulus package US$565 bn. Investment on infrastructure and social welfare...A good precedent? •What will future finance look like? 1. Feldstein and Horika (1980) finding about high correlation investment/saving still valid (e.g. Aizeman et. al. 2004). More emphasis on domestic resource mobilization in future? 2. Paradoxically, banking may benefit (in a shift towards German/Japanese/Korean model?). But a more conservative structure, with less innovation in financial innovations. 3. A shift in favour of more long-term investment and against short-terminism in equity markets? (see the Michael Porter critique (1992) on allocative efficiency of US market)‫‏‬ OECD Development Centre

Every cloud has a silver lining? (2) ‫‏‬ 4. Desperate need for global standards – OECD has a major role to play here in corporate and financial standards, etc. 5. Opportunity for reform of global financial architecture 6. Nothing is wrong in principle with CA deficits, especially when they reflect the use of foreign savings to enhance investment, but since the 1990s deficits have generally tended to favour consumption, and have often been associated with falling savings ratios in rich industrialised countries (e.g. US, UK, the Netherlands, Sweden, Italy, Finland, Canada and Australia) (Glyn, 2005:66). Some order and discipline needs to be restored to international financial flows? OECD Development Centre

Policy issues arising from the crisis – Every cloud has a silver lining? Current Account (Im)balances, 2007, billions US$ Source: IMF WEO October 2008 40 OECD Development Centre

Finally.... a cautionary note on economic forecasting IMF growth projections vis-a-vis real performance, 1998-2008 Source: IMF WEO various issues 41 OECD Development Centre

Thank You The Development Centre www.oecd.org/dev Andrew.Mold@oecd.org

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The Fallout from the Crisis: Perspectives for Development Finance

by OECD Development Centre, Paris on Nov 20, 2008

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