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Making the Poor more Resilient to Overcome Future Crises
Role of the World Bank1
UC Davis, April 28, 2010
Justin Yifu Lin
Senior Vice President and Chief Economist
The World Bank
It is a pleasure to speak at this forum on a topic central to the World Bank’s mandate of sustained economic growth and poverty reduction. I will focus my remarks today on the role that governments and the World Bank can play in making the poor more resilient to crises.
In any crisis, the poor are especially vulnerable, as they lack the resources to cushion its impact or take ameliorative actions. The 2007-2008 food and fuel (FF) crisis pushed about 135 to 150 million people into poverty. While food and fuel price increases have receded since 2008, the financial crisis that came on the heels of the FF crisis will cause an additional 64 million people to fall into extreme poverty by the end of 20102.
Moreover, such crises not only push people into poverty, but they also have an impact on other dimensions of well-being that can leave long-term scars. As parents lose their jobs and their income suffers, investments in children’s health and education may also be reduced with the consequent impact on child malnutrition and education enrollment. As a result, aggregate income shocks that reduce investments in children’s development may have a long-lasting impact on poverty and its intergenerational transmission thereby depriving children of their ability in the future to participate in and reap the benefits of a prosperous economy3.
Crises are likely to be a continuous feature of the economic landscape. In the future, we will experience other food and fuel crises, financial crises and possible crises related to climate change. Under these circumstances, the focus on enhancing the capacity of the poor to cope with crises is not only pertinent, but also timely. In this effort, governments and the international community –including the World Bank - play a crucial role.
In my remarks today, I will start with a brief discussion of the 2007-08 food crisis and then discuss more broadly the issue of economic crises. In both cases, I will be highlighting the role that governments and the World Bank can play in helping the poor to cope with these phenomena. I will conclude with a few key remarks.
2. Food Crises
The main characteristic of the market for food crops is the inelasticity of demand (i.e. people cannot consume less than minimum subsistence levels). For this reason, the most important factor that explains food crises at the country, regional, or international level is changes in food supply. Any changes in supply, even small changes, will have a considerable effect on prices. Changes in the supply of food originate from two main causes: (i) changes in production due to weather (droughts, floods) and (ii) trade policies in neighboring countries that reduce food exports to thin international markets causing huge increases in international food prices, which can be easily transferred to domestic food prices.
These sharp food price increases have the greatest impact on the urban poor, who are the most vulnerable as net food consumers. In urban areas farming is almost non-existent; hence poverty levels are highly sensitive to food prices. Rural areas, in contrast, contain both net consumers and net sellers. The World Bank estimates that the food crisis increased poverty by 2.9% in urban areas and by 2.1% in rural areas, World Bank (2009).
Among the government interventions that can help the poor to cope with their vulnerability to food prices are policies designed to make food production more resilient. These policies include investment in irrigation and agricultural technology as well as better management of food reserves. Raising the incomes of the poor is the most effective long term mechanism for reducing their vulnerability to higher prices of staple foods. One policy that governments may pursue is to improve the technology of production available to all farmers which in turn will increase food production and substantially reduce poverty (Ivanic and Martin 2008). A strong case can also be made for government policies that invest in irrigation and rural infrastructure. Improvements in rural infrastructure raise the prices received by producers for output, lower the cost of consumption goods brought in and can be very effective in lowering poverty. In addition, investment in irrigation and rural infrastructure are highly complementary - for example, improved crop varieties require investments in infrastructure, such as irrigation, if they are to succeed (Lin and Martin 2009).
The government can also use existing food reserves to reduce the volatility in prices attributed to changes in production. If current food production diminishes, for example, as a consequence of bad weather, the government can reduce the food reserves to stabilize prices, which will benefit the poor.
The World Bank can support these government policies by using its knowledge as well as lending capacity. The World Bank can provide technical assistance and funding to support countries’ investment in technology, irrigation, rural infrastructure as well as on other instruments to manage risk in agricultural markets.
b. Trade Policies
A change in the supply of food not only originates from production changes due to weather shocks, but also from protectionist trade policies implemented by the main exporting countries. While in the short term these trade policies can have the desired effect in the countries implementing them, they may cause further international price increases by reducing grain exports, and thus aggravating the crisis (fallacy of composition). In this context, governments can advocate for free trade and collective action through the UN, G-20, or WTO and establish agreements against the use of protectionist policies.
The 2007-08 food price crisis also highlighted the role of speculation in food price volatility. Rising expectations and hoarding played an important role in the increasing level and volatility of food prices, as did the flow of speculative capital from financial investors into agricultural commodity markets. In light of these problems, a number of recent proposals have been made to establish global collective actions for preventing the problems associated with extreme food price spikes, without attempting to stabilize grain prices (von Braun and Torero 2009; and von Braun, Lin, and Torero 2009). One proposal is the establishment of an internationally coordinated grain reserve to minimize the risk of individual countries trying to achieve grain self-sufficiency by rebuilding their own public reserves which could result in a very inefficient global production system, a large total global reserve, and a very thin global grain market. The second proposal is a “virtual reserve” under which an administering body, backed by a financial fund, would sell forward contracts in order to set a future price below the current spot price, hence reducing the incentive for speculative holding of grain in times of shortage. In view of the adverse effect that grain price spikes have on poverty, proposals such as the ones discussed deserve further study and consideration.
The World Bank is well positioned to be of assistance in the international domain by promoting free trade and implementing global actions to mitigate the impact of food prices on the poor. As a response to the food crisis, and in line with its mandate to alleviate poverty, the World Bank started a Global Food Crisis Response Program (GFRP) in 2008. The GFRP is a rapid financing facility which currently fosters medium and long-term investments aiming at boosting agricultural productivity and market access in low income countries. In addition, during the G-20 meeting in Pittsburgh in September 2009, the leaders call on the World Bank to develop a trust fund to scale-up agricultural assistance to low income countries.
3. Economic Crises
Recent history has shown that economic crises can originate in developed countries and are not only the dominance of developing countries. Nevertheless, no matter where a crisis originates; the poor are the most vulnerable group. For this reason, an economy that can generate greater job and income opportunities will be better prepared to help the poor to cope, not only with food crises but, with economic crises more broadly (home-grown or global), since the main source of income for the poor, especially for non-farm laborers and landless farmers, is their labor earnings.
A government that adopts a comparative advantage-following (CAF) strategy at each stage of its development will create more job and income opportunities for the poor and will be characterized by a pro poor growth trajectory. In particular, a CAF strategy is a strategy that pursues a set of policies that facilitate the development of industries and the adoption of technology that follows the comparative advantage determined by the country’s evolving endowment structure at each ‘stage’ of development4.
In most cases, a developing country is relatively abundant in labor in comparison to capital. Thus, if the country follows its comparative advantage in economic development, it will develop labor-intensive industries and will create greater job opportunities which favor the poor, whose main source of income is labor earnings. Moreover, the economy will be competitive in domestic and international markets because its industries will follow the country’s comparative advantage5. Therefore, under a CAF strategy, the country will produce the largest possible economic surplus and will have the highest returns to investment so that capital will be accumulated faster and in this fashion the country will change its endowment structure from relatively abundant in labor to relatively abundant in capital. The industries in the country will upgrade from relatively labor-intensive to capital intensive and the wage rate will increase accordingly. Therefore the poor, who rely on wage earnings, will increase their income.
A country that follows its comparative advantage to develop its economy will also have fewer home-grown crises because its industries are competitive and therefore, the economy is less likely to have systemic crises due to domestic factors. Moreover, as its industrial upgrading relies mainly on its own accumulation of capital instead of borrowing abroad. The country is less likely to be exposed to crises arising from currency mismatch and will also be more resilient to external shocks because on the one hand, the government’s fiscal position is likely to be strong due to the strong growth performance and on the other hand, its external account is likely to be more sound due to the competiveness of the economy. Therefore, when external crises, like the one from which we are currently emerging, occur the government will be in a better position to adopt countercyclical policies.
The above analysis suggests that if the development of industries in a country follows its comparative advantage, its economic growth will be relatively sustainable and inclusive, compared to the alternatives. Firms in a country care about profits, thus firms will choose industries according to the economy’s comparative advantage, determined by the endowment structure, only if the relative prices reflect the relative scarcities of factors. The relative prices will possess such characteristics only if the markets are competitive. Therefore, the first role of the state in adopting a CAF strategy is to improve the market function in the economy. As capital will be accumulated quickly if the country’s development follows its comparative advantage, the industrial upgrading will also be relatively fast. For the industrial upgrading, the state can also play a facilitating role by providing information about which industries are likely to be consistent with the new comparative advantage of the economy, coordinating required public and private investments in hard and soft infrastructure for the upgrading, and compensating firms with externalities to other firms in the upgrading process (Lin, 2010).
However, even if a country follows a CAF strategy, economic crises cannot always be avoided, both home-grown and external, and many people will be pushed into poverty6. Therefore, the government needs to implement a social protection strategy well targeted to the poor and vulnerable. For example, work programs, cash transfers or conditional cash transfers, will help to mitigate the welfare impact on the poorest families while also promoting longer-term recovery (Ravallion 2008).
The World Bank can play a fundamental role both in helping countries to follow a CAF strategy as well as in implementing effective social protection programs. The World Bank is a knowledge bank and therefore can help countries to design and implement industrial policies which are consistent with a CAF strategy. Also, the World Bank can help developing countries to improve the effectiveness of their social programs by tapping into the experience of countries with a long experience of implementing effectively these programs, as is the case in some Latin American countries (Fiszbein and Schady 2009). The World Bank has lending facilities which can be used for both these purposes.
Economic crises will be a recurrent feature of our landscape so it is important that the World Bank is able to respond quickly and flexibly to the demand of its clients. In order for the World Bank to respond to these challenges posed by the FF and economic crisis as well as fulfill its development mandate, a capital increase will be needed.
The main messages of my remarks today are:
- First, in any crisis the poor are especially vulnerable as welfare losses tend to persist beyond the crisis itself. In this setting, governments can play an important role in alleviating the impact of crises.
- Second, in order to alleviate the impact of food crises on the poor. Governments can support enhancements in agricultural productivity through investments in irrigation, agricultural technology and rural infrastructure.
- Third, at the global level, it is imperative to keep markets open, free and refrain from raising barriers or imposing new barriers to trade. Moreover, global collective actions such as the establishment of an international grain reserve and a virtual reserve may help to prevent problems associated with extreme food price hikes.
- Fourth, in order to lessen the impact of economic crises on the poor the best strategy in the long run is for the country to adopt a comparative advantage following strategy (CAF). This will allow the country not only to achieve strong economic growth, but also have a strong fiscal and external position to pursue counter-cyclical policies.
- Fifth, social protection responses have a special role on crises by helping those who are relatively uninsured to cope with crises.
- Sixth, the World Bank as a knowledge bank can play an important role in making the poor more resilient to future crises by providing advice alongside funding to developing countries to implement the above policies and programs.
1Paper prepared for the annual speech organized by the Giannini Foundation of Agricultural Economics at UC Davis on April 28, 2010. A short version of this paper was presented at panel on the Financial and Economic Crash of 2008 and Its Impact on Food and Agriculture in Developing Countries organized by International Food Policy Research Institute, Washington DC, on December 3, 2009. The help from Claudia Sepúlveda and Frances Cossar for preparing this paper was most appreciated.
2For the impact of the 2007-2008 food and fuel crises on poverty, see World Bank (2009). For the impact of the financial crisis on poverty see World Bank (2010). The latter updates the calculations presented in Chen and Ravallion (2009).
3Research has shown that these linkages are more complex than it has often been assumed. Ferreira and Schady (2009) have shown that the linkages depend on the interplay between income and substitution effects. In richer countries, like the United States, child health and education outcomes improve during recessions. In poorer countries, mostly in Africa and low-income Asia, child health and education are pro cyclical. That is, infant mortality rises and school enrollment and nutrition fall during recessions. In the middle-income countries of Latin America, health outcomes are generally pro-cyclical and education outcomes counter-cyclical.
4For a thorough analytical as well as empirical discussion of the role that a comparative advantage-following (CAF) strategy and its opposite, a comparative advantage-defying (CAD) strategy may have in a country’s development process. See Lin (2009).
5Porter (1990) made the term ‘competitive advantage’ popular. According to him, a nation will have competitive advantage in the global economy if the industries in the nation fulfill the following four conditions: 1, their industries intensively use the nation’s abundant and relatively inexpensive factors of production; 2, their products have large domestic markets; 3, each industry forms a cluster, and 4, domestic market for each industry is competitive. The first condition in effect means that the industries should be the economy’s comparative advantage determined by the nations’ endowments. The third and the fourth conditions will hold only if the industries are consistent with the nation’s competitive advantage. Therefore, the four conditions can be reduced to two independent conditions: the comparative advantage and domestic market size. Among these two independent conditions, the comparative advantage is the most important because if an industry corresponds to the country’s comparative advantage, the industry’s product will have a global market. That is why many of the richest countries of the world are very small (Lin and Ren 2007).
6One caveat is of crucial importance. Careful management of the capital account liberalization in developing countries is required to minimize the occurrence of external crises.