A couple of friends of mine have already asked me "So what if a couple of banks go bankrupt? Who cares about bad mortgages? What is all the big deal about?" It is hard to explain in few words why the financial sector is so vital in modern economies, when countries are as strongly connected by trade ties as it is currently the case.
Probably the best way to explain its importance is by thinking of the economy as a machine and the financial sector as a lubricant. The financial sector's role is to efficiently allocate capital from savers to investors.? Financial markets lubricate the rest of the economy's productive activities.? Thanks to this lubrication, the economy is able to "work harder" and make fuller use of all the cogs in its machinery. If financial markets stop functioning, then the machine would not be able to work as efficiently as before, because it would lack the lubrication needed to keep full speed. This is in a nutshell why Washington has bailed out the financial sector, without even thinking about it, but appears much less willing to help the collapsing US automobile manufactures.
A second important aspect to take into account of financial markets is that banks are strongly connected to each other. If GM closes down tomorrow, other surviving businesses, such as Toyota, will probably benefit. However, in financial markets, if one financial agent, for example a bank, suffers, due to the interdependencies in the system, many other banks will suffer too. If one bank fails, other banks will tend to fail as well. This domino effect is something characteristic of industries with businesses which are tightly connected with each other and strongly dependent of each other's actions.
As financial markets have grown increasingly global, the allocation of capital from savers to investors has become global. As a consequence of the US financial crisis, BoP markets will probably suffer in the coming year.
It is important to note that BoP markets had already absorbed a strong shock with the food and fuel price rises in the last 2/3 years. In my post
on June 2008, I estimated that the percentage of income spent on food might increase from 58% (as calculated by The Next 4 Billion
) to 75% - 80%. The World Bank has estimated
that as a consequence of such price rises the population of people living in extreme poverty in East Asia, the Middle East and South Asia has increased by 1%, at least 100 million people.The impact on urban poor was particularly acute. Although food and fuel prices have now fallen, reducing consumption from very low levels can have important irreversible 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 (more than the population of the states of Texas and New York combined). Fuel and food shocks have also debilitated the macro-economies of many emerging countries, undermining their ability to respond to the financial crisis. Data from a recent IMF survey covering 161 countries show that nearly 57% of countries reduced taxes on food and 27% reduced taxes on fuels.
So how will the current financial crisis affect emerging countries in 2009? The UK’s Overseas Development Institute
(ODI) notes two possible transmission mechanisms
- Through financial contagion across stock markets: as capital has been withdrawn from emerging country stock markets, equity value has fallen and the interest paid by firms for borrowing through the stock market has increased (more technically, bond spreads have increased). As of mid-October, developing country equity markets had given up all of their gains in 2008 and initial public offerings (one of the main ways to raise capital for small firms seeking to grow) had all but disappeared.
- The financial crisis has resulted in an economic downturn in developed countries which may impact developing countries in three important ways:
- Remittances to developing countries will fall: Although the impact on each country will depend on exchange rates, aggregate world remittances will fall in 2009. In fact, they have already slowed down in the second half of 2008. Also, the economic slowdown will especially reduce employment opportunities in the developed world in the sectors with a high concentration of migrants, such as construction, retail or catering.
- Fall in trade volumes: World trade volumes may fall for the first time since the 1982 recession, led by the pulling back of international bank lending.
- Foreign direct investment will come under pressure: Investment was the main driving force for developing country growth over the past 5 years, contributing almost half of the increase in domestic demand. Private flows into developing countries are projected to decline from $1 trillion in 2007 to around $250 billion in 2009 (or from 7.7% to 3.0% of the developing country GDP). Additionally, aid commitments are likely to come under pressure too.
As a result of all these concerns, growth in developing countries, which had been expected to reach 6.4% in 2009, has already been marked down to 4.5%. The World Bank predicts that this crisis, just like the previous one, will hit the poorest and most vulnerable groups hardest
, pushing more people into poverty and malnutrition.
It is hard to find room for hope amid such gloom predictions. As multinational agencies struggle to contain the crisis, it is the responsibility of the BoP community to join the fray at the micro-level. In times of need, lessons derived by BoP businesses will prove very useful in keeping low-income communities with their heads above the water and will show how private sector initiatives can offer sustainable alternatives to stimulate growth. Year 2009 may be the year in which BoP business models show their real worth in the fight against poverty. After all, it is only in times of need when one knows which friends we can truly count on.