This year’s edition of Global Development Finance, the report by the World Bank on the state of the international economy focuses in its entirity on the global finanxcial and economic crisis, its current and projected impact on both developed and developing countries and the prognosis for recovery. The report, as the editorial in the June 19th issue of the Stabroek Business put ot represented “more bad news” for poor countries. In this issue we publish the overview to the World Bank’s report on Global Development Finance
Part II
Building confidence and strengthening policy coordination arecritical to recovery and long-termgrowth
Among government officials, policy makers,and key market observers, calls to restore confidence in the global financial system have become an international mantra. A quick Web search of major media, for example, shows that the number of occurrences of “restore confidence” in October 2008 was 624 percent higher than the average for the first six months of 2008.
Governments have, by and large, “walked their talk” through a furious combination of unilateral and multilateral actions, drawing on a broad range of conventional and unconventional monetary policy, fiscal stimulus, and government guarantee programs to shore up the banking industry. Such actions have achieved some easing of liquidity conditions in global interbank markets, have supported a narrowing of credit risk premiums, and have underpinned a tentative revival of equity markets.
However, the policy agenda for stabilizing financial markets and for global economic recovery is broad and complex, and major challenges remain.
Several overarching themes will remain salient for policy makers over the next few years:
The global nature of the financial crisis places a premium on policy coordination
The deep international economic linkages among countries that provide the channels for negative spillovers across borders also enhance the scope for beneficial policy coordination. Indeed, efforts to stimulate aggregate demand through expansionary monetary and fiscal policies, to recapitalize insolvent financial institutions, and to restore the functioning of credit markets through the provisionof liquidity are more likely to be taken—and are more likely to be effective—if there is broad agreement among the major governments on policy direction.
Governments’ willingness to coordinate their policies can help reestablish confidence by ruling out beggar-thy-neighbor responses to the crisis.
The danger of special interests using trade policy to protect particular industries is especially severe in a downturn. As for financial policies, measures taken to recapitalize commercial banks with public funds have introduced pressures for banks to concentrate lending activity on the domestic market (the socalled home bias in lending practices), at the expense of cross-border lending. In the years leading up to the crisis, a defining feature of global finance in developed countries was the escalating integration of the household sector into capital markets.
Excessive credit creation, made possible through the technology of asset securitization, yoked consumer spending to the expansion and profitabilityof the banking industry, with both serving as engines of economic growth. As household ownership of equities and bonds increased, households’ wealth and income became more closely linked to capital markets, forging closer linkages between the real economy and financial markets—and increasing the likelihood of political intervention when trouble appears. In the United States, for instance, almost half of households currently own equities or bonds, up from 39 percent in 1989.
While the case for fiscal policy coordination is weak in normal times—because countries normally face very different challenges and priorities— it is called for today, as all countries are facing the same prospect of inadequate global demand. Stimulating aggregate demand through fiscal expansion is in everyone’s interest at the moment, but each country will be reluctant to undertake it on the necessaryscale because some of the expansionary effects will spill over to other countries, and because any country that acts alone—even the United States—may reasonably fear that increases in government debt will cause investors to lose confidence in its fiscal sustainability and so withdraw financing. Both of these constraints will be lessened by a commitment to coordinate a fiscal expansion globally. A joint international commitment to maintaining open markets for goods and services must be a central feature of governments’ policy responses.
A balance must be struck between national and international mechanisms for improved regulation and crisis prevention
In designing and implementing reforms to strengthen financial markets and regulatory regimes, the first line of responsibility lies with national regulators, but greater international financial cooperation among regulators is an unavoidable imperative. Although changes in national regulations have begun to improve transparency and thwart excessive risk taking, today’s highly integrated financial markets necessitate close coordination among authorities in order to bolster market confidence and avoid regulatory arbitrage.
The international spillovers of the crisis in the financial area presently provide a powerful incentive for harmonization, because concerns over stability temporarily outweigh the urge to seek advantages for the “home team.” It should be remembered, however, that regulatory cooperation is often resisted in normal times by policy makers eager to protect or enhance the competitive advantage of financial firms based in their own country.
Analysis conducted for this report suggests that not only the incentive for coordination, but also the gains to be had from it, are largest when there is a large common shock to confidence. But coordination must be in addition to, rather than a substitute for, national action. Because national regulators have the best access to information on their domestic institutions, they must retain principal responsibility for ensuring the stability of their own financial systems—without angling for a competitive advantage for domestic firms.
Over the medium term, governments must reestablish fiscal sustainability
Recent measures by central banks in the Euro Zone, Japan, the United Kingdom, and the United States to purchase private and government debt as a way of unfreezing credit markets have led to a significant expansion of their balance sheets and rapid growth of the monetary base in these countries, a process that has replaced, to a large extent, the accumulation of foreign exchange reserves by other central banks as the main engine of global liquidity.
Rising public debt levels and the rampant expansion of central banks’ balance sheets will pose considerable challenges to economic stability once the recovery gets under way.
The major industrial countries began the crisis with moderate debt-to- GDP ratios. However, the unprecedented amounts spent to bail out financial firms have already substantially inflated those ratios, and governments have taken on contingent liabilities in connection with various financial guarantees, the potential effects of which on government debt are unknown.
Discretionary fiscal stimulus, as well as the operation of automatic stabilizers, will further increase debt ratios, perhaps doubling them in some countries if the downturn turns out to be as severe as is now envisaged. Government commitments will have to be financed, if not through taxation, then through the issuance of debt obligations.
As the fiscal implications of such commitments are factored in, interest-rate expectations will be adjusted upward, raising the cost of capital for all borrowers, including those in developing countries.
The damage to low-income countries from the crisis must be mitigated
With so much at stake, there is an urgent need for the international financial community to take a hard look at recent developments, assess the vulnerabilities and risks that are the unintended products of current policy interventions and market changes, and evaluate the likely effects of those interventions and changes on development finance. Most of the available resources to be provided by the IMF and other international financial institutions are likely to be devoted to high-income emerging markets and middleincome countries that are likely to be able to repay the loans they receive.
In this climate, low-income countries that are already under strain deserve special attention. They have had little or no access to private foreign capital even in good times. A combination of policy and market failures has restricted their participation to occasional project finance deals, largely in extractive industries, and to the short-term loan market, mostly bank loans for trade financing.
That sobering fact should reinforce the importance of broad international agreement to mobilize the necessary resources to achieve the MDGs.
After several decades of debt rescheduling through the mechanisms of the Paris Club, the sequence of official debt relief programs initiated under the Heavily Indebted Poor Countries measures of 1996 and culminating in the launch of the Multilateral Debt Relief Initiative in 2005 stand out as a remarkable exercise of multilateralism and sound economic sense.
With fewer resources now available in low-income countries to service external debt, it is especially important that the world should build on—and certainly not back out of— those agreements.
These are the themes and concerns of this year’s edition of Global Development Finance
