Periodic crises have had real but varied welfare impacts: WB

Written by Sanjay Jog | Mumbai | Updated: Dec 24 2008, 05:33am hrs
The World Banks report Lessons from past on financial crisesreleased on Tuesday observed the benefits of financial development and globalisation have come with continuing fragility in financial sectors. Periodic crises have had real but varied welfare impacts and not just for the poor people. In fact, a few conditions that foster deep and persistent poverty, such as lack of connectivity to markets, have protected poor people to some degree.

Past crises have also had longer-term impacts for some, notably through the nutrition and schooling of children in poor families. The report highlights the importance of spending composition in designing a fiscal stimulus or adjustment program. Sound information on what is happening on the ground as the crises unfolds is also crucial. A key lesson from past experience is that short-term responses macro economic stabilisation, trade policies, financial sector policies and social protection cannot ignore longer-term implications for both economic development and vulnerability to future crises.

Another less is financial sector policies need to balance (understandable) concerns about the fragility of the banking system with the needs for sound longer-term financial institutions. And the social policy response must provide rapid income support to those in most need, giving highest on the poorest amongst those affected, while preserving the key physical and human assets of poor people and their communities. Difficult choices will be faced in addressing the (inevitable) trade-offs between rapid crises response and these longer-term development goals.

According to the report, crises continue to be contagious, due to the real and financial channels that fundamentally connect countries. It is difficult to achieve the benefits of economic and financial integration without being susceptible to contagious effects, although the terms of this important trade off depend on a number of aspects of the financial integration process, including how much the country relies on foreign direct investment (FDI) versus other types of private capital flows, the extent of reliance on short-term debt, and simply whether the country is part of the portfolio of international investors.

The most direct channel linking the developed world to the financial crises emanating from the developed world in 2008 is through exposure to assets that are at the heart of the crises, notably (though not only) the sub-prime mortgages. However, the more important channels for most developing countries will probably be indirect, notably through trade (via declining demand for developing-country exports or declining export process, including commodities), investment (as external finance contracts) and remittances (also stemming from the recession in the developed world).

Moreover, among the sources of external finance to developing countries, only foreign aid tends to be stabilising, in the sense that its volume rises when economies contract. Private sources tend to be destabilising, but some more than others; remittances are the least destabilising, followed by FDI, while other private capital flows are the most destabilising. The relative volatility of non-FDI capital reflects the responses of international investors to (among other things) default risks. Report has pointed to the importance of a sound legal framework and stable political environment in attracting foreign capital, and to the influence of a countrys history of default on capital flows.

Many developing countries are now quite strongly connected to the world economy through these various channels. Their growth prospects will be adversely affected by a slowdown or a recession in industrial countries.