By Justin Yifu Lin
The hottest topic today is the financial crisis while the United States and Europe are the focus of attention, but I am more concerned about developing nations.
The economic crisis of 1929 caused the US unemployment rate to soar while the economy went into recession, with many negative impacts on the country. However, because there was no globalization at that time, the crisis did not affect other countries significantly.
This time around, the main cause of the problems is that financial innovations went too far, with insufficient supervision to rein it in before they developed into a full-blown financial crisis. And, because it is in the era of globalization and many European and Asian financial institutions also hold American bonds, the scope of damage is much wider.
From 2002 to 2007 the global economy achieved unprecedented fast growth, especially in developing countries. It is the fastest economic growth developing nations have seen since the end of World War II.
As for the driving forces behind developed countries' economic growth, I think the reason early on is that financial liberalization and relaxed regulation helped their economies to grow faster than before. After the September 11 incident the US increased defense spending while adopting an aggressive financial policy.
Meanwhile, as a result of the bursting of the dot-com bubble, the country went for an expansionist monetary policy, which is the recent and more important reason. Between then and now the Federal Reserve (the Fed) has made 27 interest rate cuts to prevent the economy from slipping into recession. The cuts led to greater money supply, increased liquidity, higher consumption and investment boom.
The third reason is the expanding real estate bubbles found in the US and other developed countries, which triggered consumption frenzy. Come to think of it, the aggressive monetary policy back then sowed the seed of today's financial crisis.
The US subprime meltdown started in 2007 and escalated into a full-scale financial crisis. It reduced the attainability of funds while jacking up the cost of financing. This was directly reflected in the shrinking possibility of overnight inter-bank borrowing, to the point that banks could no longer borrow from one another.
The lenders were so worried about the risk of a bank run that they dared not lend money to others even when they had some to spare. At the same time the asset effect was diminishing fast, as seen in the plummeting property and equity share prices.
The global economy is expected to deteriorate fast, with the US, Europe and Japan staring at zero and even negative growth next year, according to some predictions. It is a common understanding of the business community everywhere that developed economies will sink into recession.
Currently the US dollar appears to be rebounding, but the danger of future devaluation is very real. This financial crisis is not just America's but the world's as well. Relatively speaking, the US is still an aircraft carrier and therefore remains an emergency shelter for funds even though it is the epicenter of the raging financial tsunami.
Capital may flow back to the US in the short term but, because the financial crisis forced the US to inject a huge amount of cash into the banking industry, the US dollar will lose value in the future and flow away again.
Today, as external demands wane, developing nations' export is in a nosedive, while the sources of capital for these countries are also disappearing. Direct foreign investment and equity investment are shrinking; and commodity prices are falling.
For instance, the price of crude oil has plummeted from $140 a barrel earlier this year to around $70 a barrel these days; while the price of copper ore has dropped by 60 percent. This means dramatic decrease of revenue for resource export-oriented countries. Also, the contracting labor markets of developed nations mean less and less foreign currency remittance for developing countries.
The impact of the crisis is continuing, as the effects of the second round are showing up: first, some projects have been suspended halfway through; second, completed projects have created excessive productivity and threaten to turn into bad debts or even crises for banks, while stock markets continue to fall, contributing to the financial crisis and payment crisis. The crisis not only causes economic slowdown but also leads to crises within developing countries.
Today there is nothing more urgent than preventing financial institutions from going under. On the other hand, in terms of monetary policy application amid falling commodity prices and deflation, governments should help relatively competitive industries upgrade by easing monetary control. Financial policies should also provide support for infrastructure development and upgrading.
It is necessary to keep infrastructural development running on the heels of fast growth of non-state economy, inject capital into social security, education and medical service, and invest in the future productivity of economic entities.
The key is to stimulate demands in the counter-cycle so as to protect the economic fundamentals and prevent the financial crisis from turning into a "crisis of human survival and development".
As for developed nations, every country must reach a consensus on sharing the overall cost - the sooner the better. Also, developed countries must not erect trade barriers or cut down economic aid, which would exacerbate the impacts of the crisis on developing countries.
It's time for all parties concerned to do what they can. For example, the International Monetary Fund (IMF) can provide financial backing for countries threatened by crises in financial balance and offset the expected drop in non-government capital flow; countries with abundant foreign reserves can supply the IMF with funds. The Japanese finance minister proposed at the IMF annual meeting last month that Japan is prepared to take $200 billion out of its $1 trillion foreign reserve as provisional funds. That is a very good idea.
The World Bank can offer capital support to the above-mentioned infrastructural development projects and humanitarian help to social investment projects in developing nations; the International Development Association (IDA) can help the low-income economies; the International Bank of Reconstruction and Development (IBRD) can support the medium-income countries; and the International Finance Corporation (IFC) can lend a hand to developing nations handicapped by weak capital structure. In a word: financial institutions are obliged to help where they are needed most.
How serious is the impact of the financial crisis on China? The country will fare better than most others because it has three lines of defense - up to $1.9 trillion worth of foreign reserve, no danger of capital escape thanks to capital account control; and relatively good fiscal health with surplus. This will come in handy when the nation implements the strategy of boosting domestic demand. Personally, I think expansionist fiscal policy is more effective than monetary policies at the moment.
Premier Wen Jiabao said recently: "Maintaining fast economic growth is China's greatest contribution to the world." The country's economic growth slowed to 9 percent in the third quarter, which aroused worldwide concern.
Why so? Because the Chinese economy accounts for 10 percent of the world economy. Ten percent growth in China will translate into 1 percent of growth for the world. China is a country of insufficient resources, which means huge demand for resources such as copper, iron and oil when its economy grows fast. That will no doubt lead to more export revenue for and economic growth in nations that sell those resources.
China can sustain economic growth by implementing appropriate monetary and fiscal policies and do many other things, such as cut bank interests, lower provision rate of bank deposit, reduce capital cost, increase capital supply and allow enterprises to upgrade.
It can also shift its fiscal focus to rural and infrastructural investment, social security improvement and increasing investment in social development to boost economic growth.
The recent economic slowdown in China reminds us it is necessary to stay vigilant even in good times, but I believe it is totally possible that China will keep its growth rate between 8 and 9 percent.
The author is a vice-president and chief economist of the World Bank.
(China Daily November 5, 2008)
