The Implications of Global Crises on Developing Countries, The Millennium Development Goals, And Monterrey Consensus

Follow-up International Conference on Financing for Development to Review the Implementation of the Monterrey Consensus

Doha, Qatar

29 November - 2 December 2008

  Background Paper, World Bank Group

The Implications of Global Crises on developing countries, the Millennium Development Goals, and Monterrey Consensus

The world economic outlook has worsened dramatically. The intensification of the financial crisis in the United States and its rapid spread since the middle of September to both other high-income and developing countries has led to a dramatic deterioration in growth projections. Economic growth in developing countries, which had been expected to register 6.4 percent in 2009, has been marked down to 4.5 percent and in high-income countries, many of which have already entered into recession, average growth is now expected to turn marginally negative in 2009. Growth is projected to recover in 2010, although there is considerable uncertainty and much will depend on the policy responses in developed and developing countries. Global trade, which grew by 9.8% in 2006, is projected to fall in 2009 for the first time since 1982.

Virtually no country, developing or developed, has escaped the impact of the widening crisis, although countries that entered the crisis with stronger fundamentals and/or less integration into the global economy have generally been less affected. Of the 20 developing countries whose economies have reacted most sharply to the deterioration in conditions (as measured by exchange rate depreciation, increase in spreads, equity market declines and large current account deficits), seven come from Europe and Central Asia, and eight from Latin America.

Impact on developing countries

Earlier this year, amidst historically high food and fuel prices, the global community’s attention was focused on the impact of these shocks on poor countries and vulnerable populations. The rise in food prices between 2005 and early 2007 was estimated to have increased the share of the population of East Asia, the Middle East, and South Asia living in extreme poverty by at least 1 percentage point, a setback equivalent to seven years of progress toward meeting the poverty MDG. The impact on the urban poor was particularly acute, increasing the incidence of poverty by more than 1.5 percentage points in East Asia, the Middle East, South Asia, and Sub-Saharan Africa.

As a result of the food and fuel crises, the number of extremely poor was estimated to have increased by at least 100 million. The poverty deficit (the annual cost of lifting the incomes of all of the poor to the poverty line) rose by $38 billion or 0.5 percent of developing country GDP.

Equally worrisome was that many of those already poor were slipping even more deeply into poverty. Recent estimates show that poverty is deepening (i.e., the gap in consumption between the average poor household and the poverty line), with the extremely poor being hit hardest. Eighty-eight percent of the increase in urban poverty depth from rising food prices was from poor households becoming poorer and only 12 percent from households falling into poverty.

Recent declines in food and fuel prices do not imply that pressures and problems have disappeared. For the very poor, reducing consumption from very low levels, even for a short period, can have important long-term consequences. Already during 2008, higher food prices may have increased the number of children suffering permanent cognitive and physical injury due to malnutrition by 44 million. This represents a tragic loss of human and economic potential. Many of the countries most exposed to high and volatile global food and fuel prices are those with high pre-existing levels of malnutrition. Burundi, Madagascar, Niger, Timor Leste and Yemen are among the ten most affected countries for both stunting and wasting indicators.

The challenges faced by developing countries earlier this year have now been compounded by pressures emanating from the global financial crisis.  The sudden deceleration of capital inflows will force a sharp adjustment in private-sector activity. There is a high probability of balance sheet deterioration and possible banking crises where banks and nonbank financial institutions have expanded credit to the private sector most rapidly. There may be an especially direct impact in economies where there has been substantial borrowing from foreign banks, either through their subsidiaries in the domestic market or through by local banks.

Investment is expected to bear much of the direct impact of the financial crisis. Investment was the main driving force for developing-country growth over the past five years, contributing almost half of the increase in domestic demand. For 2008, investment is expected to increase only moderately in middle-income countries, compared with 13 percent growth in 2007. There is a risk that investment in developing countries may be headed for a “perfect storm,” with a convergence of slowing world growth, withdrawal of equity and lending from the private sector, and higher interest rates, with a further risk that lower commodity prices in the medium term will deter new investment in natural resource sectors.

Policy Challenges from the Financial Crisis

Should the freeze in credit markets not thaw quickly enough, then the consequences for developing countries could be severe. Financing conditions would deteriorate rapidly, and otherwise sound domestic financial sectors could find themselves unable to borrow or unwilling to lend both internationally and domestically, and domestic productive sectors would be deprived of working and long-term capital. Such a scenario would be characterized by a long and profound recession in high-income countries and substantial disruption and turmoil, including bank failures and capital account crises in many developing countries. Sharply negative growth in a number of developing countries would be inevitable along with all of the attendant repercussions, including increased poverty and unemployment.

Remittances from host countries are expected to decline in response to the global slowdown but the impact on flows to recipient countries will depend significantly on exchange rates. Remittance flows from host to developing countries, which reached an estimated $295 billion in 2008, began slowing in the second half of 2008 and are projected to slow sharply in 2009.  In 28 developing countries, remittances received were larger than revenues from the most important commodity export, and in 36 countries they were larger than private and public capital inflows. However, the large exchange rate fluctuations of recent weeks have dwarfed the expected changes in remittances when denominated in host-country currencies. As a result, changes in the local currency value of remittances will likely vary widely by country. Overall, remittance flows into developing countries are expected to decline from 2.0 to 1.7 percent of recipient country GDP.  The global slowdown is also expected to lead to a sharp reduction in employment in the developed world, especially in sectors with a high concentration of migrants (e.g., construction, retail, catering).

Remittances are a powerful poverty reduction mechanism. For example, in Nicaragua remittances reduce poverty incidence by four percentage points on average, and five percentage points in urban areas. In Albania, households with migrants to Italy and Greece have an incidence of poverty that is half the national rate (i.e., 15 and 19 percent compared to an average of 32 percent).

Low-income countries (LICs) will be significantly affected by the crisis even though the relative significance of particular channels of transmission will be quite different from emerging markets. Financial sectors in LICs are less integrated into global financial markets. As a result, the direct impact of the crisis is likely to be more limited. Nevertheless, LICs will be impacted through slower export growth (global trade is projected to decline in 2009), reduced remittances, lower commodity prices (which will reduce incomes in commodity exporters) and the potential for reduced aid from donors. The crisis is also likely to result in a reduction in private investment flows, making already weak economies even less able to cope with internal vulnerabilities and development needs.

The financial crisis and the resulting abrupt slowing of global growth occur as many developing countries have become more vulnerable. High and volatile commodity prices have raised the current account deficits of many oil-importing countries to worrisome levels (they exceed 10 percent of GDP in about one-third of developing countries), and after having increased substantially, the international reserves of oil-importing developing countries are now substantially decelerating

The global financial crisis will pose major fiscal challenges for developing countries. In the coming months, developing countries will see growing fiscal pressures both on the expenditure side (growing demands for social protection, recapitalization, etc) and the revenue side (as exports and economic activity slow). The appropriate response to falling domestic demand may, in some cases, be a measured fiscal stimulus. However, the credit crunch and flight from risk is already reducing the ability of countries which previously had market access to meet gross financing needs.

The food and fuel price shocks have already imposed large fiscal costs on developing countries, undermining their ability to respond to fall-out from the financial crisis. Policymakers responding to high food and fuel prices made extensive use of tax reductions to offset higher prices and increased spending on subsidies and income support. Data from a recent IMF survey covering 161 countries show that nearly 57 percent of countries reduced taxes on food while 27 percent reduced taxes on fuels. Almost one in five countries increased food subsidies while 22 percent increased fuel subsidies.

The reliance on “across the board” tax reductions and subsidies was unfortunate because these measures are often regressive, costly, and difficult to reform once in place. Fuel subsidies are usually more regressive than food subsidies and often have adverse environmental consequences. Reliance on inefficient fiscal measures such as untargeted subsidies is also regrettable given the need to create the fiscal space to accommodate a permanent increase in the size of targeted safety nets[1]. Careful fiscal planning is needed to protect critical growth-enhancing spending, prune low-priority expenditures and ensure fiscal sustainability in the medium term. These pressures will only increase as the global financial crisis takes it toll.

The sharp reversal in commodity prices may require equally dramatic adjustment among commodity exporters. While the terms of trade deterioration faced by food and fuel importers has begun to reverse, exporters of these commodities are facing sharp declines in prices with potentially large implications for their current account positions. At the same time, a large group of developing countries have become heavily reliant on foreign financing in recent years, whether in the form of aid or private capital flows. Around half of all developing countries have current account deficits in excess of 5 percent of GDP and about one third have current account deficits of over 10 percent of GDP. Should the current extreme liquidity squeeze persist, it is bound to have repercussions for global growth and the capacity of countries to obtain external finance. There is evidence of this already.

Policy Priorities

Many developing countries have to make efforts to ensure that resources are put to their best and most efficient use. As underscored in Monterrey, the countries that are likely to perform better are those that have managed to reduce macro-financial vulnerabilities, increase investment rates, diversify export markets, and restore productivity growth. In these uncertain circumstances, policymakers must place a premium on reducing the impact on their domestic economies by reacting swiftly and forcefully to emerging difficulties.

Policymakers must also protect the real sector by taking measures to maintain the flow of short-term and trade credit necessary for economic activity. In the current climate of heightened risk aversion and investor skittishness, policymakers need to be especially wary of taking on excessive levels of debt or creating the conditions for an inflationary bubble by too aggressive a reaction to the global slowdown. It also means continuing to improve the investment climate for private investment, to increase the flexibility of the private sector to adjust to changing market conditions (business entry and exit) and to generate new jobs and tax revenues.

The challenge is not just to prevent the escalation of the crisis and to mitigate the downturn, but also to ensure a good starting position once the recovery is underway. This means responding rapidly and forcefully to signs of weakness in financial sectors, including resorting to international assistance where necessary. It also means pursuing a prudent counter-cyclical policy, relying on automatic stabilizers, social safety nets, and infrastructure investments that address bottlenecks that have become binding constraints on long-term sustainable growth.

Efforts to expand and improve the targeting of social safety nets must be sustained. This is particularly crucial if the impact of a slowing global economy is to be contained. Of the options available, targeted cash transfers tend to succeed best because they have relatively low administrative requirements and minimize the diversion of benefits toward less needy population groups. However, in-kind programs, such as school feeding and the distribution of fortified weaning food for toddlers, can be effective; Whatever policies are adopted, it is critical that the offsetting income support be clearly presented as temporary to avoid creating an unnecessary and unsustainable fiscal burden.

Lessons from earlier crises point to the importance of safeguarding investment in long-term development. The only way to sustainably reverse the income losses facing the poor will be through economic growth. Developing country governments need to balance immediate crisis response with the imperative to restore high quality economic growth over the longer term and re-start progress towards the Millennium Development Goals. If growth leaves out the poor, or is cut short because of inadequate structural reform, recovery will not achieve its promise.

Many developing countries are financing their own adjustment to shocks, but at a significant cost in terms of growth and development. In the wake of the financial crisis, it is therefore imperative than donor countries meet their part of the bargain, as agreed in Monterrey. It is more critical than ever that the international community acts in a coordinated and supportive fashion to make each country’s task easier.

The Financing for Development conference in Doha provides an opportunity to reaffirm a mutual accountability framework anchored to a strong country-based development model.   Following Monterrey, there was hope that international development efforts to support the MDGs would gain momentum.  The implementation of major debt relief initiatives (e.g., Heavily Indebted Poor Countries Initiative, Multilateral Debt Relief Initiative), the recovery of Official Development Assistance flows (vis-à-vis the trends in the 1990s), the Gleneagles Commitments on scaling up aid (particularly to Sub Saharan Africa), as well as the Paris Declaration on Aid Effectiveness and innovations in resource mobilization for development (e.g., the International Financing Facility for Immunization) embodied that hope.  Yet the international community faces an increasingly demanding agenda in pursuing the MDGs as 2015 draws nearer.

It is imperative that donors meet their Gleneagles’ commitments. Prior to the financial crisis it was already apparent that many donors were moving too slowly to meet their Gleneagles commitments to debt relief and scaled-up aid. For example, while assistance in the amount of US$117 billion (in nominal terms) has been committed to the 33 post-decision-point HIPCs (mostly under the HIPC Initiative and through the MDRI), to reach their Gleneagles commitments, the international community will have to increase ODA by some $40 billion in 2004 real terms between now and 2010 (including about $30 billion from the G7).

The Monterrey Consensus noted that external debt relief plays a key role in freeing up resources to help HIPCs attain sustainable growth and achieve the MDGs. Substantial progress has been made since Monterrey and the HIPC Initiative and the MDRI have proven effective in addressing the debt burden of highly indebted countries. To date, 33 out of 41 eligible countries have qualified for HIPC debt relief. Of these, 23 have been granted irrevocable debt relief under the HIPC Initiative and the MDRI. As a result of these, and other debt relief initiatives, the debt stock of the 33 post-decision-point HIPCs is expected to be reduced by about 90 percent. The magnitude of the MDG challenge, however, remains daunting and the environment in which poverty reduction efforts are undertaken is arguably getting more difficult as countries must now also cope with new challenges.

Developed country policymakers must also avoid putting in place policies and structures that undermine the interests of developing countries. In recent years, many developing country governments have taken courageous steps to put in place sound macro and fiscal policies.  They now find themselves at the mercy of a crisis not of their making. A retreat to protectionism or economic nationalism by developed countries will hurt them even further.

Trade reform needs to be part of the solution. Steps are required to sanction effectively countries that use export restrictions as a mechanism to control domestic prices. Not only do such restrictions interfere with the domestic supply response, they also exacerbate price hikes and shortages in the rest of the world. Although a successful conclusion to the WTO Doha Round of multilateral trade negotiations might result in higher prices in the short run, it would likely prove beneficial to developing countries by improving the competitiveness of their agricultural sectors and reducing their reliance on imported food.

A vigorous crisis response can set the stage for a new multilateralism. There is a mismatch between 20^th century global institutions and 21^st century global challenges. The G7/8 is no longer sufficient. A new approach should not be built around a fixed or unitary system, but should involve a flexible network of countries and institutions, maximizing the strength of interconnected global actors, including not just the existing institutions such as the World Bank, the IMF and the United Nations, but also private sector firms and civil society organizations. This new Economic Multilateralism must be inclusive and pragmatic, embracing not just trade and finance, but development, climate change, fragile states, and energy. It must look beyond the G7/8 to include not just the rising economic powers but representatives of the poorer countries as well.

The crisis has highlighted the need for reform of the Bretton Woods Institutions. A modernized World Bank Group must represent the international economic realities of the 21st century, recognize the role and responsibility of growing stakeholders, and provide a larger voice for Africa. Voice and participation considerations require early resolution by World Bank shareholders. Last month, shareholders endorsed an initial package of reforms. As a next step, shareholders agreed that the Bank should undertake a comprehensive and intensive work program to realign bank shareholding, moving towards a more equitable distribution of voting power between developed and developing countries. Work on this next stage is beginning now, and must proceed quickly to consensus. The Zedillo Commission, created by President Zoellick to look at World Bank Group governance more broadly, is expected to report next year.

Conclusions

Multilateral cooperation is needed if we are to meet the internationally-agreed development goals (MDGs) and ensure inclusive and sustainable globalization. The MDG challenge remains daunting and the environment for achieving poverty reduction has become more difficult. The mutual accountability compact laid down in Monterrey, adapted and extended to reflect the changing global environment provides a solid foundation on which to build a more comprehensive framework to address global issues.  More specifically:

·         Developing countries (particularly those endowed with natural resources) should reaffirm their commitment to the mobilization and deployment of domestic resources to promote more inclusive and sustainable growth. The ratification of the UN Convention Against Corruption (UNCAC) and other measures to deter asset theft and facilitate their recovery (e.g., the StAR initiative), countering illicit financial flows as well as helping countries manage their natural resources (EITI++) could be important pillars of this framework.

·         With growing global imbalances, current account surplus countries should commit to provide more aid and financing to support the increased needs of developing countries in line with the Paris Principles of Aid Effectiveness and consistent with debt sustainability. Debt relief, while welcome, addresses only a relatively small part of HIPCs’ financing needs and cannot ensure debt sustainability permanently. Addressing HIPCs’, and more generally LICs’, development needs therefore requires higher new aid flows and debt relief. Special attention should be given to the potential role that sovereign wealth funds (SWFs) could play in promoting investment in developing economies. These new flows could allow for a quick and targeted response to address any emerging issues, such as high and volatile food and fuel prices. Lending from SWFs needs to be on appropriate terms to preserve the benefits of debt relief

·         DAC donors should match these efforts by mobilizing additional resources from a range of sources -- public and private -- expanding innovative mechanisms for financing development needs and improving upon the predictability of ODA flows.

·         But only LIC borrowers themselves can ensure that debt remains manageable over the long term. It is therefore essential that the international community support efforts to improve debt management practices in LICs. With the objective of strengthening the debt management capacity and institutions in these countries, the World Bank has recently launched the Debt Management Facility.

·         Attention to climate change should be better integrated with core development work. But LICs also need assurance that resources allocated to mitigation and adaptation to climate change will not detract from other development needs. Aid provided to developing countries on this front should be additional to existing levels of assistance. In addition, acceleration of technology development and transfer could also play an important part in forging a globally acceptable and actionable outcome.

·         Finally, the expanded compact should reaffirm the critical role international organizations must play as public good providers to address market failures and to assist developing countries with technical and financial support.

The World Bank stands ready to play its part. In terms of responding to the most immediate challenges presented by the financial crisis, the Bank is stepping up its assistance to its clients on a number of fronts:

·         The IBRD is positioned to make new commitments of up to $100 billion over the next three years.  This year alone, there is scope to almost triple lending from its 2007 level to more than $35 billion;

·         Following its record 15th replenishment, IDA is in a strong position to assist countries in dealing with the impact of the global financial crisis, with total commitment authority amounting to nearly $42 billion over the next 3 years, and scope for front-loading,

·         The Bank is also ramping up its support through the IFC by doubling the Global Trade Finance Program to $3 billion and launching a global equity fund (with support from the Government of Japan) to recapitalize distressed banks.  IFC is also establishing a new facility to provide roll-over financing to existing, viable, privately funded infrastructure projects facing financial distress.  For this latter effort, the IFC expects to invest at last $300 million and mobilize between $1.5 billion and $10 billion from other sources. 

·         MIGA is also providing guarantees to foreign banks to help inject liquidity and bolster confidence in Ukraine’s and Russia’s financial system.  Similar guarantees are expected in Eastern Europe and Africa.

·         Working through these and other instruments, such as the Energy for the Poor Initiative and the Global Food Crisis Response Facility, the World Bank Group can help protect the poorest and most vulnerable from immediate and long-term harm, support the financial and private sectors hard hit by the crisis, assist countries in managing the fiscal challenges, and build a platform for recovery and long-term development.

One of the most important roles for the World Bank Group is to help developing countries minimize the disruption of ongoing development programs and projects. This includes helping governments prioritize their own scarce resources and sustain external financing of existing development projects and programs. Without a doubt, the unfolding global financial crisis will have major repercussions on the infrastructure development plans of developing countries. But infrastructure remains a top priority for addressing developmental gaps. Therefore, as developing country budgets adjust to a new fiscal reality, careful management will be necessary to protect long-run investment in infrastructure and social development and avoid unnecessary cuts in essential public expenditure. Efforts should be made to sustain spending on operations and maintenance so as to avoid deterioration in existing infrastructure that will be expensive to reverse in the future. 

IBRD and IDA financed Development Policy Operations will help partner countries finance their deficits and adjust their expenditure and revenue policies to take account of the priorities and pressures emerging from the crisis. This work will be coordinated with the IMF and other partners. Crisis-related investments in social protection and recapitalization and post-crisis adjustment must be additional to the current full range of projects and programs. Indeed, given the pressures on governments’ own resources, IBRD, IDA and IFC will in some cases need to support additional projects and programs in infrastructure and human development.