Monday, 15 December 2008

The Economics of Developing Nations and the Global Financial Crisis

More than ever before in human history, our countries are linked in a complex economic framework which creates dependencies between all nations. In a privileged interview, Thought Economics speaks to Professor Wim Naudé, (Senior Research Fellow and Project Director of the United Nations University World Institute for Developing Economics Research) and discuss the interdependence of nations, economics of world development, the effects of the global economic crisis on developing nations, free market economics, commodities, corruption, and what the developing world can teach our markets.


December 15th 2008, Thought Economics, Vikas Shah

Over Thousands of Years”, observed Amartya Sen (Nobel Prize Winning Economist), “globalisation has progressed through travel, trade, migration, spread of cultural influences and dissemination of knowledge and understanding”. Our immediate history has seen huge acceleration of this globalisation process, fundamentally altering the way in which people, nations and companies interact. An explosion in communications technology now means that at an instant we can tap into the total sum of human knowledge and experience, communicate instantly without borders, and instantly broadcast news events, from anywhere in the world, globally. These same advancements, combined with radical changes in political and social attitudes have also created incredible growth in international trade (seen with China becoming the world’s ‘producer’ and India serving many of the world’s service industry requirements) together with an environment where capital can now flow more freely between nations allowing greater opportunities for investment, and financial trades.

Globalisation has, though, not been without problems, and alongside the wealth and benefits our world has seen, we are now left with a global economy which is on the brink of recession, where we still observe staggering and inexcusable levels of poverty and conflict and the paradox of ‘developed’ economies in huge debt, with the ‘developing world’ holding massive reserves of currency, and the world’s natural resources.

In 1973, the United Nations established a decentralised university (the United Nations University - UNU) to “…contribute, through research and capacity building, to efforts to resolve the pressing global problems that are a concern of the United Nations, its Peoples and Member States.”. This body has grown and matured into a decentralized, global network comprising UNU Centre in Tokyo, a worldwide network of UNU Research and Training Centres/Programmes, and liaison offices at United Nations headquarters (New York) and UNESCO headquarters (Paris). The UNU now employs over 336 research staff across its thirty global locations. As part of the United Nations University, the World Institute for Development Economics Research (UNI-WIDER) was established in Helsinki, Finland in 1984, to undertake applied research and policy analysis on global development and poverty issues.

In a privileged interview, I spoke to Professor Wim Naudé (Senior Research Fellow and Project Director at the UNU-WIDER). Professor Naudé’s recent research focuses on spatial economic inequalities, entrepreneurship and African economic development. Previously, he has been Director of the Work Well Research Unit at North-West University, South Africa, and a Council Member of Statistics South Africa. He has also been lecturer and research officer at the Centre for the Study of African Economies, University of Oxford, has taught economics at Addis Ababa University, and has worked as policy researcher in a number of African countries.

Q: How dependent are emerging and developing economies from capital inflows from 'western' and other developed regions? And what has been the impact to developing economies on the massive reductions of liquidity, growth, and sentiment in the 'developed' world?

[Prof. Wim Naudé] The essence of the evolving global economic system is that all countries are dependent on one another in some way, and this includes finance. Emerging and developing countries are dependent on capital inflows from developed regions. But developed regions are also dependent on funds from the developing world! Consider for instance that the bulk of the world’s foreign exchange reserves – trillions of dollars – are held by developing economies, and that the US runs a current account and budget deficit of astronomical proportions.

As far as emerging and developing economies are concerned, they have traditionally been very dependent on capital inflows from the rest of the world, especially from high-income countries. These capital inflows consists of aid, portfolio investments, direct investments (FDI) and remittances. Each of these is important to different countries in different contexts. For instance, many small countries such as Lesotho, Cape Verde, Haiti and others depend crucially on remittances from their workers earning incomes in developed economies. Larger emerging markets such as China have benefited hugely from FDI – which has brought with it technology, know-how and best practices. Others again, like South Africa, have used the inflow of portfolio investments to continue financing a current account deficit. And then there are countries, like the group of least developed countries, who depend on aid disbursements from donor governments, mainly in the ‘west’.

Following the financial crisis that originated in the rich countries in 2007 and 2008, there have understandably been fears that capital flows to developing countries will decline. Although it is too early to give adequate numbers, current estimates range that capital flows to developing countries could decline by between US $ 300 and 400 billion. The eventual extent will depend on a number of factors and will differ between countries depending on their macroeconomic stability and macroeconomic management in place. Thus, many countries will be maintaining good fiscal discipline and positive real interest rates, as a result of which they may be benefiting by re-attracting investment flows from the developing world where interest rates are at historic lows.

Depending on what happens to commodity prices, FDI in developing countries may also resume, albeit more cautiously (much FDI in developing countries is related to their booming commodity sectors). Also, if expansionary policies in the US and EU work out to be effective in stemming the depth of the recession, the impact on remittances may be lessened. Finally, with regard to aid, it has been argued that countries should now increase aid to vulnerable countries, particularly those facing the scourge of the twin deficits (fiscal and currency account) and with a heavy dependence on the US economy. Statements from the recent Doha Conference on Finance for Development have been encouraging, and may hold the promise that aid will not be reduced.

Q: Many argue that to provide monetary development support artificially accelerates regions to grow faster than would be pragmatic, what is your view? And is the 'free market economy' principle indeed appropriate for all countries?

[Prof. Wim Naudé] Monetary support for development in itself will not accelerate growth in the real economy to artificial or unsustainable levels. It is how the finance is used – or misused. What we have seen in the present crisis is a combination of cheap and easy credit, weak regulatory control, financial ‘innovation’ that resulted in financial instruments that could not (or would not!) be assessed accurately. This resulted in over-investment in the housing market with a housing asset price boom – which further encouraged credit expansion. Once the bubble burst and borrowers started to default, the house of cards collapsed. Banks were overleveraged and are now trying to rectify the situation, and as a result we are feeling a credit crunch. The artificiality and unsustainability comes in when loans are made to customers who cannot repay those loans, and without sufficient collateral.

Otherwise, credit and loans are vital to sustain economies, and banks remain vital intermediaries between those with surplus funds and those who require funds. Therefore, as financial markets grow and becomes more interconnected, it is important to regulate and supervise these financial markets. Although one does not want to see government ownership of banks (that comes with an entire other set of problems as the Asian Crisis of 1998 has shown) governments should ensure that these banks do not engage in overtly risky practices, that they do keep sufficient capital as a bulwark against risk (and preferably in cash) and that the incentives for managers and traders do not encourage them to take excessive risks. They should also extent this oversight and regulation not just to banks, but to all institutions that are heavily leveraged. Finally developing countries should learn from the US experience and ensure through regulation, competition policy and under measures that no single firms becomes so important that it is judged ‘too big to fail’.

Q: How do the prices of commodities (e.g.: metals, oil, soft-commodities) impact developing economies?

[Prof. Wim Naudé] The excellent growth in developing countries as a group since 2001 (peaking at around 8 per cent in 2007) is in many due to the rapid increase in commodity prices, which in turn has been growing due to the demand from large emerging markets such as China, India and Brazil. In these countries, growth has been export led. With their foreign currency reserves improving, and government revenue increasing, countries are obtaining better ratings (and better conditions for sovereign debt). Poverty has been falling in Africa, Asia and Latin America.

Having said that, there are a number of developing countries, many of them amongst the least developed countries, who are not commodity exporters, and who have suffered due to the high prices of oil, cement, and more recently of food. Many of these countries have over the past year been experiencing balance of payment stresses.

Q: In terms of economic growth, which are the countries 'to watch' in your opinion and why?

[Prof. Wim Naudé] Countries with commodities that are still in demand, and for which demand over the long-term is unlikely to decline much, such as oil, will continue to grow. But the countries that will grow fastest over the next few years will be those countries that have done the most during this past commodity and growth cycle to invest their gains in infrastructure and education and where the gains have been distributed is such a manner so that the middle class have been growing most substantially. This will allow such countries the ability to better utilize domestic resources (including taxation) as well as to diversify their economies in light of changes in the world economy. More than ever perhaps, countries with an evolving entrepreneurial economy will be able to achieve faster growth. These are economies with a conducive environment for the private sector to flourish – with political stability, strong property rights, the rule of law and an independent judiciary for instance as important requirements.

Q: Transparency International's Corruption Perception Index shows many developing economies as having high levels of corruption and low transparency. Why are corruption levels so high in these regions, and do you think this plays a big role in preventing these regions from growing?

[Prof. Wim Naudé] Yes, corruption is an obstacle to growth. Essentially, corruption entails a misallocation of entrepreneurial talent into activities that carries individual benefit, but has destructive or unproductive consequences for society at large. Because of its essentially predatory nature, it reduces productive investment, leads to an outflow of talent, lowering growth rates and increasing income inequalities.

Ideally, such talent should be re-allocated into productive activities. How does this come about? Well, it depends on the incentive structure in society, which is the outcome of the broad institutional features (the ‘rules of the game’) in such societies. For example without an independent and strong judiciary, there might not be sufficient incentives to remain within the law and corrupt activities may never get prosecuted. Without sufficient transparency in awarding government contracts, incentives for fair and objective treatment might be low.

In many countries with poorly developed institutions, the existence of precious natural resources turn out to be a curse rather than a blessing, since these resources are ‘lootable’, and individuals and groups face little checks and balances in wanting to capture these for themselves.

Q: In many Asian and African countries, we have seen that rapid economic growth has led to the widening of the wealth gap, and a reduction in social mobility, what are your views on this?

[Prof. Wim Naudé] It would seem that there will always be people who are unsatisfied with economic growth, both when we have to little and when we have too much. Thus there will always be a debate on the trade-off between high growth and equity, whether growth is sufficiently ‘pro-poor’ or not, whether the benefits of growth will ‘trickle down’ or not, or whether growth is sustainable or not, whether it is harmful to the environment, etc. This reflects the fact that there is much of the nature of the economic growth process that we do not understand fully.

What we do know is that growth results from both endowments of resources and appropriate skills – and because not all individuals or countries have similar endowments and/or appropriate skills at any particular time, they will not be able to contribute equally towards growth and thus sharing equally in such growth. This is why most countries, depending on the degree to which they are tolerant of inequality, give the government a role to play in transferring resources from the rich to the poor – through for instance progressive taxation and other measures.

What we also know however is that over the longer-term, sustained economic growth can make a significant dent in absolute poverty. We have seen it in the history of the US, we have seen it in Japan and the East Asian ‘Tigers’, and we are seeing it now again in emerging markets such as China, India and parts of Africa. So growth should remain an important objective, and countries should in their own ways deal appropriately with the implications if growth is accompanied by rising inequalities.

Q: Does economic inequality lead to crime in developing economies? And do you think that following the economic crisis and impending recession/depression in western economies, can we learn lessons from these regions?

[Prof. Wim Naudé] Yes, I think that inequalities do breed opportunities for crime, although the causes of crime are more complex. But inequality also breeds resentment, especially if such inequalities are also along racial and/or ethnic lines. In such a way it diminishes a country’s ‘social capital’, which is an important mechanism for preventing crime. In many countries with high inequality and poor social capital we see that the formal criminal justice system being overburdened.

As far as the second question about lessons from the crisis is concerned, yes, I am sure there are useful lessons to learn. There have been many financial crises in developing countries. A recent IMF study has identified more than 100 such financial crises since 1970. Many lessons have been learned from these crises that could be useful even now. For instance, after the 1998 Asian crisis many countries in the region moved towards reducing government ownership of their banks, and improved bank regulation and capital adequacy requirements. They have consequently survived much of the current fallout. In contrast, governments in the US and EU have been nationalizing banks. It is not clear yet how they will get out of this, or avoid the hazards (including the moral hazards) of owning banks.


The world (particularly Europe and the USA) has undergone a historic change in recent months, with most analysts agreeing that the global economic environment “from here” will be radically different to the past. We have also seen, with great clarity, that the effects of a financial crisis in one country will now quickly spread around the world, exposing the interdependencies and links between our nations. We re also likely to see phase-shifts in economic power, as Asian and middle-eastern nations start to increasingly flex their financial muscle on a global scale, and perhaps this will also help further free capital and trade flow across borders increasing transparency, and helping to further society as a whole.

The argument over whether recent globalisation has contributed to poverty remains, as do the many political and social problems preventing our intervention to cure it, but the phenomenon of globalisation itself, is a force which we cannot ignore, and as the dust settles on our current economic crises, and eyes turn again to growth, we will see the continuity of the observation made by Nicholas Stern (World Bank Chief Economist) who said, “An increase in international trade and investment through multilateral trade reform is not an end [to poverty] in itself, but a potentially powerful means of reducing poverty worldwide.” but as Kofi Annan himself stated, “We must ensure that the global market is embedded in broadly shared values and practices that reflect global social needs, and that all the world's people share the benefits of globalization.



United Nations University:

World Institute for Development Economics Research:

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