Wednesday, 1 December 2010

The financial crisis, the import collapse and the developing countries

Despite green shoots in the OECD and strong growth rates in China and India the world economy is not out of the woods yet. In 2007 the most serious global economic crisis since the 1930s started and many developing and emerging economies (DEEs), that since the mid 1990s had opened up to the world economy, are now experiencing the down side of strategies that - for good reasons - relied heavily on international trade and foreign direct investment to achieve national development.

What was expected
When the financial crisis burst out in 2007 the majority of economists was not expecting the DEEs to be hit hard. A first, often-mentioned, reason was that developing countries had not engaged in the kind of financial whiz-kidding that had created the enormous bubble in the OECD. Thus it was assumed by many analysts that the DEEs would not suffer a fall-out from the banking crisis which after all was a problem of the OECD countries. A second reason was the myth of decoupling: the non OECD, in particular the BRIC countries (Brazil, Russia, India and China) were assumed to have reached sustainable momentum in their development trajectory. It was expected that the experience of the dotcom crisis (when the BRICs were able to show continuous growth independently of the weakening OECD business cycle) would be repeated.
Both ideas were dangerous and wrong (and actually not new at all as the belief that the periphery could escape the financial collapse in the centre was also widely shared in the early 1930s when it proved to be erroneous). It is true that some of the BRICs continued to grow considerably but the sustainability of growth in 2010 and beyond is not self-evident because the main driver of those expansions (monetary and fiscal stimulus) cannot be expected to last forever. More importantly, smaller DEEs probably did not experience this momentum and may have been hit hard.

What is happening
We do not yet know what happened in many countries, simply because real time data for a sufficient level of analysis are not available. This means that we have to do some economic detective work and use the method of indirect observation to infer if and how the crisis hits the DEEs. We can, for example, take a look at more aggregate data in order to glean the impact of the crisis on the DEEs. In today’s world many channels exist through which economies are linked. International flows such as remittances, bank lending, migration and development aid are influenced by the downturn in OECD economies. An example is the amount of Official Development Aid (ODA). Last year the OECD’s
Often the measurement of these flows is imprecise and data become available with considerable delay. Better data exist for Foreign Direct Investment (FDI) and especially for international trade and therefore we will take a closer look at these international flows. After six years of uninterrupted growth, FDI flows to developing and transition economies, according to 
Some argued that these developments could be a symptom of a process of deglobalization. Others blamed a collapse of trade finance (which is particularly relevant for DEEs) and an increase in protectionism for the declines. It is, however, important to note that the trade and investment contractions took place in a policy context that by and large appeared to have been withstanding the temptations of protectionism and, moreover, the G20 made additional trade financing of US$250 to US$400 billion available, including instruments to mitigate risks and liquidity support. The collapse of international exchange, in other words, could have been much larger if inappropriate policy responses had occurred.

 
Informative as such observations may be, they do not yet provide an indication of the actual impact of the crisis in individual countries. If we want to observe the impact of the crisis on a specific country, one of the best methods is to observe the development of the volume of imports. This is so because trade flows, unlike more comprehensive and complex phenomena such as (national) income are observed reasonably accurately and published without much delay. Exports and imports do not, however, provide the same sort of information about the condition of the economy of DEEs. Actually exports often do not provide a meaningful picture of the impact of a crisis. A decline in domestic demand may, for example, induce firms to find new markets abroad and, if policy makers respond with devaluation, one would expect exports to increase in the aftermath of a financial crisis. This is all the more true as policy makers typically opt for an export led growth strategy to get out of a crisis situation. Resources are thus often re-allocated towards the export sector in order to ensure that hard currency can be earned, for example, in order to be able to meet international debt obligations. Exports thus actually may tend to grow during and after financial crises. From a political economy perspective the perception may be relevant that imports entail an outflow of hard currency. Thus policy makers might not be inclined to come to the aid of importing firms (unless the imports are crucial for the exporting industry). Payment risk is especially relevant for the importer who will experience a rise in transaction costs, for example, because letters of credit or even full payment in advance is required. The reduction in effective demand that is a consequence of a financial crisis directly translates into a reduced import volume. Finally, in a scenario that involves a depreciation of the currency, the price of imports will rise and thus exert a negative influence on the volume of imports. All in all the impact of a financial crisis should be expected to be most visible and unambiguous in the development of the volume of imports.

Where does the crisis hit?
Figure 1 analyses the decline in the volume of imports in a cross-country setting for a group of 45 countries over the years 2007 to 2009. This group of countries covers the OECD and the major DEEs (China is not included because the data are insufficiently comparable). The Figure compares the peak and the trough of the import cycle over this period. The figure first of all illustrates the large variation in country experiences. The Netherlands registers one of the smallest import contractions (of about -11 per cent); the largest contractions of some - 45 per cent occur in Belarus and Venezuela. Importantly, the figure relates this decline to the level of development (which is approximated by the income per head in US dollars). The dotted regression line indicates that lower income per head is associated with stronger contraction of the volume of imports. The observation that the DEEs (have to) reduce their import expenditures to a much larger extent suggests that they are hit harder by the crisis than the richer countries. Of course this is not a direct observation but the finding that many DEEs are adversely hit by the crisis is corroborated by other more advanced techniques such as the World Bank’s applied microsimulation models which also show that these macroeconomic effects trickle down to the (new) poor and especially a middle income group of ‘crisis vulnerable’ with substantial poverty and distributional effects and potentially important effects on long term growth. It is also important to note that imports in the National Accounts are subtracted in order to arrive at Gross Domestic Product. A contraction of imports will thus paradoxically influence GDP upwardly. This may make the National Account figures look more positively than the actual ‘underlying’ development of consumption, investment and net government expenditure. The upshot is that a recovery of GDP may be less sustainable than expected.
All in all, the important conclusion of this article is that the developing and emerging economies particularly have experienced very substantial declines in import volumes. The implication is that these countries must have been hit relatively hard. Importantly, the contraction of imports will limit their prospects over the medium term, because development requires imports of capital goods, raw materials, intermediate goods and essential consumer goods. The contraction of imports may thus act as a future drain on development and the influence of the crisis will go 
beyond the direct economic impact, for example because health care has to be cut down. The World Bank/IMF Global Monitoring Report 2010 The MDGs after the Crisis analyses the impact of decelerating growth on human development indicators finding that life expectancy at birth on average declines by 10 per cent as infant and child mortality increase by 50 to 75 per cent respectively. Against this background the development of ODA is even more disappointing.
Imports provide a good indication of crisis impact
Development Co-operation Report 2009 estimated that the underlying trend growth rate of the volume of aid needed to increase to 11 per cent per year in order to achieve the Millennium goals. The results in 2009 were, however, disappointing as the amount of aid increased by 0.7 per cent only. Importantly this is not the result of increased spending but of exchange rate movements that contribute more than 4 percentage points. Actually total ODA in current prices and at current exchange rates decreased from US$122 billion in 2008 to 119 billion in 2008 (actually 12 OECD countries reduced ODA). UNCTAD’s recent Global investment trends monitor, declined in 2009 by 35 per cent and 39 per cent, respectively. Export volumes also showed substantial declines. According to the World trade monitor (compiled by CPB Netherlands Bureau of Economic Policy Analysis) DEEs real exports at the start of 2010 were some 12 per cent below their previous high (the peak of the trade cycle is in 2008). Experiences at the regional level showed a lot of variation. Asia definitely did better, but exports in Latin America had decreased by 19 per cent and the volume of exports in the Middle East and Africa was even 25 per cent below the previous peak level (the trade cycle for the latter region appears to follow a double dip pattern).