December 16, 2008— Although the financial crisis is still unfolding, it is already prompting changes in the theory and practice of financial-sector policymaking in developed and emerging countries. Michael Klein, World Bank Group vice president and IFC chief economist, shared his insights on the key debates, and his predictions regarding what lies ahead with www.worldbank.org.
First of all, how is a financial crisis that started on Wall Street impacting developing economies?
Let me first say that the current crisis was shaped in the United States by its unique, complex financing structures—structures which are generally not found in emerging countries. But emerging countries have been hit by the drying up of credit, reduced remittances, and lower export demand. The poorest of the world were also recently hit by a food and fuel shock. This additional financial and fiscal shock may carry severe consequences. I discussed the impact of the crisis on developing countries (pdf) in some detail in a speech delivered in Munich last month.
Are initial steps to stem the crisis in the US and Europe affecting developing economies?
In a word, yes. Although, of course, the answer is complicated. In the United States, Europe, and elsewhere, we have seen unprecedented assurances to bank depositors and creditors. Some arrangements include blanket guarantees on deposits and guarantees on new debt issues, as seen in Hungary.
With the world’s financial markets increasingly interdependent, this could create competition between jurisdictions. For example, offshore financial centers that are unable to match blanket guarantees might see a decline in business. More positively, the U.S. Federal Reserve has established swap arrangements with central banks to ensure continued flows of credit have been extended to include key emerging markets such as Brazil and Mexico.
Michael Klein, Bank Group Vice President and IFC Chief Economist
So what are some immediate measures emerging countries can take to deal with the crisis and its aftershocks?
We have been encouraging emerging countries to work on their contingency planning, stress testing and coordination between agencies so that they are better prepared to move quickly to manage financial shocks. Many countries will have to take steps to recapitalize and strengthen the regulation of their banks, and may need to take measures to ensure the continued flow of credit to the economy, especially to finance trade.
What about imposing capital controls to head off possible bank runs?
History has shown capital controls carry heavy long-term costs and should only be considered as instruments of last resort. For example, in Argentina the freezing of deposits during its 2001 financial crisis seems to have contributed to poor deposit mobilization in the following years.
In the longer term, what implications might this current crisis have for the development of financial systems in emerging countries?
We may see a negative impact on capital market development in emerging countries. That’s in part because foreign investors from the United States and Europe are likely to retreat, and they were playing significant roles in emerging market development. Furthermore, we’re likely to see widespread bank consolidation as weaker players go under or get nationalized.
Do you see any new opportunities for emerging countries as the global financial landscape changes?
Actually, there may be an opportunity for a “south-south” expansion of financial services as large banks from the “north” retreat and revert to their core business lines.
What are some important lessons to take from the current crisis into the future?
Careful thought should go into ensuring sound financial regulation going forward, which takes account of business cycles. Striking an appropriate balance between financial innovation and stability will be a challenge, but it will be important to keep sight of the need to extend financial access to underserved groups, especially the poor. We’re looking for insights to help balance rules and discretion in financial supervision and regulation.
What about the on-going efforts to strengthen corporate governance?
Yes, corporate governance is an area that has already received a lot of attention internationally. But we’re still seeing breakdowns, so more work obviously has to be done. We now see that steps need to be taken to make sure governing boards understand the nature and complexity of the risk a corporation is assuming. The good news is that we can and should look to the institutions that have handed the current crisis well for guidance in the future. What about financial supervision and regulation on an international level? Any broad, sweeping changes here?
There will be vigorous debates on how much change is needed. Clearly the current framework has been tested and found wanting, but it will be some time before we reach consensus on how to adapt it. The Financial Stability Forum, a grouping of 26 national financial authorities and a number of international regulatory bodies, is likely to play a larger role in coordinating policy responses internationally, but there will also be experimentation by individual countries. My Munich speech explores this subject in some detail. What about the role of the state in a nation’s banking system?
While we are likely to see the state play a larger role in the financial sector over the next few years, it’s important to remember the negative experiences of state ownership of banks in developing countries over the longer term. History shows that permanent and pervasive state ownership is not the best way to achieve financial development and growth, or to extend access to the poor. Are there other reform opportunities that have emerged as critical as the crisis unfolds?
We haven’t talked about the need for improving accounting standards—particularly regarding the treatment of off-balance-sheet entities and fair value accounting (FVA).
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