Crisis having dramatic impact on developing countries; millennium development deadline at risk

Excessive deregulation and risk taking are at origin of financial turmoil -- huge income losses and greater poverty are the consequences, says new UNCTAD report

Geneva, 7 September 2009 -- Since September 2008 the financial crisis has turned into a full-fledged recession affecting virtually all markets and countries, either through direct financial contagion or through falling export earnings and lower migrants´ remittances. As a result, the world economy is experiencing its first contraction since the Second World War, with attendant effects on employment in all countries. The contraction now makes it virtually impossible to reach the United Nations Millennium Development Goals by 2015, says UNCTAD´s Trade and Development Report 2009 (TDR)(1).

UNCTAD economists cite deregulation of financial markets as the main cause of the global financial and economic crisis. Absence of regulation allowed uncontrolled innovation in financial instruments that obscured creditor-debtor relations and invited irresponsible risk taking. As a result, finance came to predominate over the "real" economy; a large part of the financial sector became detached from productive sectors; and the influence of speculative forces -- not only in financial markets, but in currency and commodity markets -- was strengthened, the report contends.

The Trade and Development Report 2009 is subtitled "Responding to the global crisis" and "Climate change mitigation and development" (see UNCTAD/PRESS/PR/2009/38). The study, known as the TDR, was released today.

The crisis that initially began in the financial sector now has turned into a dramatic downturn in the real economy: global GDP is expected to fall by more than 2.5% in 2009. The crisis is unprecedented in its depth and breadth, and has left virtually no country unscathed, the report says. GDP in the developed nations will contract by some 4% in 2009, and output in the transition economies is expected to fall by more than 6%. In developing countries, growth is expected to decelerate from 5.4% in 2008 to 1.3% in 2009, implying a reduction of average per capita income. Even economies that will grow this year, such as those of China and India, are slowing significantly compared to previous years.

The financial crisis spread quickly from the subprime mortgage segment of the United States´ financial market to the entire financial system of that country and, almost simultaneously, to the financial markets of other developed countries. No market was spared, from the stock markets and real estate markets of a large number of developed and emerging-market economies, to currency markets and primary commodity markets. The credit crunch affected activity in the real economy, accelerating a fall in employment and private demand and causing the most severe recession since the Great Depression. The crisis has affected most strongly companies, incomes and employment in the financial sector. But it also has had serious impacts on the construction, capital goods and durable consumer goods industries where demand depends largely on credit.

In the first quarter of 2009, gross fixed capital formation and manufacturing output in most of the world´s major economies fell at double digit rates. Meanwhile, problems with solvency in the non-financial sectors of many countries have begun to feed back into the financial system.

A sharp contraction in international trade volume mirrored the fall in manufacturing production. This in turn reduced demand for raw materials, which added to the unwinding of speculative positions by financial investors in primary commodity markets, causing a sharp correction of previously rallying prices. International trade was further affected by increasing difficulties with trade financing. In 2009, world trade is set to shrink by at least 11% in real terms and by 20% in current dollars.

Almost all developing countries have experienced sharp slowdowns in economic growth since mid-2008, and many have also slipped into recession. Some developing and emerging-market economies have proved less vulnerable than in previous crises. These are economies in Asia and Latin America that had built relatively strong macroeconomic positions before the current crisis erupted: they had avoided large current-account deficits, or even posted surpluses, in the preceding years. By contrast, many other emerging-market economies, including several in Eastern Europe, felt the impact of the crisis through a general loss of confidence in financial markets worldwide and in Eastern European markets´ abilities to cope with external financial exposure

Developing regions most severely hit by the global crisis include Latin America, where GDP is likely to fall by around 2% in 2009, with Mexico undergoing a particularly deep recession. Also strongly affected are West Asia, where several economies have been hurt by tumbling prices for financial assets, real estate, and oil, and South-East Asia, where many countries rely heavily on exports of manufactures. These regions are expected to see negative GDP growth in 2009. In Africa, output growth is expected to slow sharply in 2009, but remain positive, with anticipated growth of 3% in North Africa and 1% in sub-Saharan Africa. In the latter region it has now become virtually impossible to achieve the United Nations Millennium Development Goals by the stated 2015 deadline, the TDR 09 warns.

East and South Asia are expected to grow by 3-4% during 2009, the report says. The leading economies of these regions -- in particular China and India -- have resisted recessionary forces better than others because their domestic markets play a more important, and increasingly growing, role in total demand. Moreover, the rebound in China in the second quarter of 2009 proves the efficacy of government deficit spending if it is applied quickly and forcefully.

So far, most public resources committed to the crisis have been devoted to sustaining the financial sectors of developed countries. Monetary easing and large bailout operations may have prevented a meltdown of the financial system, but they have been insufficient to revive aggregate demand and halt rising unemployment. To stimulate demand, countercyclical fiscal policy measures that have a direct effect on aggregate demand are indispensable, and many developed and emerging-market economies have indeed launched sizeable fiscal stimulus packages. By contrast, many other developing and transition economies that had to seek financial support from the International Monetary Fund (IMF) are being given insufficient fiscal space, and must follow pro-cyclical policies as a condition for receiving the funding; while this type of conditionality appears to be applied to restore the "confidence" of the financial markets, it is often unwarranted in terms of its negative effects on employment and poverty in the countries concerned. Indeed, countercyclical macroeconomic policies are the best remedy for overcoming the current crisis.

In the current dramatic crisis situation, low-income countries require more support in the form of an internationally coordinated effort to increase official development assistance (ODA), the TDR 09 contends. In addition, a temporary moratorium on these countries´ debt owed to official creditors would help them better to maintain needed levels of public expenditure and imports. This would not only help beneficiary countries and their populations overcome the crisis, but would provide a countercyclical stimulus that could help spur global demand.

The likelihood of a recovery in the major developed countries that would be strong enough to bring the world economy back to its pre-crisis growth path in the coming years is quite low, the TDR cautions. That is because neither consumption nor investment growth can be expected to revive significantly anytime soon due to very low capacity utilization and rising unemployment. In addition, banks still need to be recapitalized and their balance sheets cleansed of toxic assets before they can be guided back to their traditional role as providers of credit to investors in fixed capital. Given the weakness in macroeconomic fundamentals, the upturn in financial indicators in the first half of 2009 is more likely to signal a temporary rebound from abnormally low levels of prices of financial assets and commodities following a downward overshooting that was as irrational as the previously bullish exuberance. The upturn is not a reflection of strengthened macroeconomic fundamentals, the report says, but of a restored "risk appetite" among financial agents, which could be reversed at short notice.

Large injections of central bank money and the sharply rising budget deficits in many countries have prompted concerns of an inflationary revival. But such risks are greatly overestimated, the report says. Discretionary increases in public spending, especially when they boost investment, may enhance production capacity and job creation, which in turn will enlarge the future tax base and thereby improve public revenues at given tax rates. In addition, with capacity utilization at historic lows and unemployment rising at a dramatic rate, there is little danger of "overheating" economies or of wage inflation for several years to come. Indeed, deflation - not inflation - is the real danger. To halt the contraction of GDP and reduce the risk of deflation, governments and central banks need to maintain, or even further strengthen, the expansionary stance of monetary and fiscal policies, the report says. Against this background, it is predicted that global GDP growth may turn positive again in 2010, but such growth is unlikely to exceed 1.6%.