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Global Economic Prospects 2000
Executive Summary
Developing countries are now recovering from the worst ravages of the financial crisis of 1997-98. The East Asian economies are rebounding from last year’s collapse in output. Improved prospects and an easing of monetary conditions in many parts of the developing world have boosted emerging equity markets and reduced interest rates from the sky-high levels of mid-1998. Developing countries also are benefiting from the acceleration of growth and interest rate reductions in industrial countries.
However, the recovery is both uneven and fragile, and many countries continue to struggle in the aftermath of the crisis. Several countries in Africa, Latin America and Eastern Europe face declines in output in 1999, and outside of Asia, developing countries’ per capita income is expected to fall. Continued imbalances in industrial countries markedly increase the risks presented by the international economic environment. Furthermore, the cyclical recovery in East Asia has not addressed severe difficulties that were either caused or exacerbated by the crisis. In addition to a review of international economic developments and prospects, Global Economic Prospects 2000 considers three areas where the crisis has had a major impact on growth and welfare in the developing world.
First, the crisis has increased poverty in the East Asian crisis countries, in Brazil and the Russian Federation, and elsewhere. Chapter 2 reviews the evidence on the crisis’ social impact on East Asia and other developing countries and addresses the broader issue of the impact of external shocks on poverty in developing countries.
Second, though the East Asian crisis countries are experiencing a strong cyclical recovery, severe structural problems remain, notably the banking systems’ high levels of nonperforming loans and the large share of insolvent firms. Chapter 3 outlines the depth of the problems faced by the corporate and financial sectors of these economies, analyzes the challenges facing the restructuring process, and discusses the appropriate role of government in supporting restructuring and reducing systemic risk.
Third, exchange rate depreciations and declines in demand in East Asia exacerbated the fall in primary commodity prices that began in 1996. Countries that depend on primary commodities have faced an enormous challenge in smoothing consumption in the face of booms and busts in commodity prices and adjusting to the secular decline in commodity prices relative to manufactures. Chapter 4 examines how the most commodity-dependent economies in the world—the major oil exporting countries and the non-oil exporters of Sub-Saharan Africa—have adjusted to the commodity price cycle.
Prospects for growth and poverty reduction in developing countries
The effects of the crises of 1997-99, from East Asia to Russia and Brazil, persist in many aspects. In most developing countries growth remains weak and well below the precrisis trends. Social dislocations are severe and progress in poverty reduction has stalled. At the same time, recent developments in the global economy have been largely encouraging, with signs of strong initial recovery in the East Asian crisis economies and continued expansion in the industrial countries leading to a bottoming-out of world industrial production and trade.
Recent events have confirmed the importance of the factors identified in Global Development Finance (March 1999) as shaping the global recovery, notably the easing of macroeconomic policies in industrial countries, early signs of recovery in the East Asian crisis countries, and easier financial conditions in developing countries. But the magnitude of these effects has been much larger than anticipated, and recent evidence has yielded some surprising developments: adjustment in some of the worst-hit countries, such as Russia and Brazil, has been much more favorable than expected in March, and a sharp increase in oil prices, following the decision of the Organization of Petroleum Exporting Countries (OPEC) in April 1999 to curtail oil supplies, has benefited developing countries that depend heavily on oil exports.
The positive evidence has been strong enough to support an upward revision of the March projections for growth. Growth for the G-7 countries this year is likely to register 2.6 percent, 0.9 percentage points higher than the forecast made six months ago. Continued strong growth in the United States is the principal factor in the revision, but Japan’s performance in the first half of 1999 (3.2 percent GDP growth), which was much better than anticipated, also contributes to the change. Europe, which had been hampered by inventory overhang, is now showing signs of a strong revival. Reflecting these developments, world industrial production appears to be on an accelerating path. For developing countries, GDP growth for 1999 is expected to be 2.7 percent—a revision of 1.2 percentage points from the March forecasts—and the outlook for 2000 has been upgraded by 0.5 percentage points.
Positive as these revisions are, they mask the considerable fragility of developing countries, which have yet to recover fully from the financial crises of 1997–99. Nor do they reflect the markedly different patterns of growth and recovery among regions. Except for East and South Asia (regions bolstered by growth in China and India), aggregate real per capita incomes in 1999 are expected to decline or stagnate in several developing regions. Further, the news since March has not been all good. The tightening of oil supply has meant higher import bills for many developing and industrial countries. And the favorable financial conditions have not made international investors less risk averse, as shown by the high levels of interest rate spreads. International capital flows to developing countries have fallen much more sharply than anticipated.
Although improving, the external environment for developing countries remains subject to a high degree of uncertainty.
The underpinnings of growth, especially in the developing countries, remain fragile. Capital flows to emerging markets continue to be scarce and expensive. In such an environment, the prospective unwinding of large imbalances in the industrial countries presents potential risks for these projections. Chief among these risks are the consumption boom (driven by the stock market) and widening external deficit in the United States, and the uncertain outlook for Japan.
One potential scenario assumes a tightening of monetary policy in the United States (in response to signs of increased inflation), which sharply reduces equity prices, resulting in slow growth in the United States and Europe and a relapse into recession in Japan. For developing countries, effects are transmitted through a further slowing in export market growth, declines in oil and non-oil commodity prices because of deteriorating demand conditions, and increased risk aversion in financial markets. Although policy responses to these external circumstances would vary widely across developing countries depending on current conditions, most countries would be obliged to adjust through a compression of domestic demand and imports. An assumed closure of the financing gap on the demand side (almost $100 billion) results in a loss of 2 percentage points of growth for developing countries as a group in both 2000 and 2001, implying a loss of nominal GDP of some $260 billion.
Long-term projections for growth in developing countries suggest that growth for the group in 2002–2008 is likely to be lower than in the precrisis 1990s.
This estimate reflects several factors, including a somewhat less favorable external environment and, importantly, prospects for a protracted work-out of structural weaknesses in developing countries¾ particularly in financial systems and fiscal positions¾ which have become more apparent in the wake of the crisis. One implication of lower long-term projections is that progress on poverty reduction will be slower. For some regions, including Sub-Saharan Africa and Latin America, reductions in poverty are likely to remain below the targets recently adopted by the international community.
Effective policy actions to encourage rapid and equitable growth are essential to reduce poverty.
External shocks, financial crises, and poverty in developing countries
The financial crisis has underlined how globalization, especially financial integration, exposes developing countries to external shocks.
External shocks can reduce the gains in poverty reduction from openness and increase poverty significantly in the short to medium term. This fact underscores the importance of addressing the issue of volatility in order to maximize the positive effects of growth on poverty reduction. The countries most affected by the East Asian crisis illustrate the asymmetric impact of changes in per capita income on poverty and the negative effects of volatility on growth.
Any development strategy for stable and sustainable growth must include both adequate safety nets and appropriate policies and institutions designed to prevent financial crises and respond when crises occur. Prospects for poverty reduction depend not only on future growth but also on countries’ capacity to manage volatility and reduce growth fluctuations.
Though less dramatic than early predictions suggested and very heterogeneous, the negative social impact of the East Asia crisis and consequent crises in Russia and Brazil has been enormous.
The increase in income, or consumption poverty, has been significant. In addition, the crisis has engendered costly, large reallocations of people and sharp declines in middle-class standards of living. Unlike the situation in Latin America, where income inequality increased significantly during crises, in East Asia the effects on income distribution have been small and highly differentiated. The extent of these effects depends on the country’s income level and the impact of the crisis on different economic sectors.
Urban poverty increased in all countries, particularly the Republic of Korea, where total employment declined and open unemployment grew more than in other countries in the region. Falling real wages in the urban formal sector affected mostly high-income groups. In Thailand the impact was felt mostly in rural areas because of the large inflows of workers from urban areas and the relatively small increases in agricultural prices.
The severity of the crisis in Indonesia is reflected in the strong responses of households to increase consumption as a share of income, adjust their asset holdings and increase the share of staple foods in their consumption baskets. In Korea and Malaysia the response of households was to increase the savings rate. The composition of consumption expenditures changed significantly. Households spent more primarily on essential items such as food, fuel, housing, health, and education.
The crisis demonstrated the flexibility of labor markets in developing countries. These markets help absorb the effects of shocks through reduced wages and labor mobility within and between urban and rural areas.
Wages fell sharply during the East Asian crisis, with particularly spectacular declines in Indonesia. Wage declines moderated the impact of the recession on employment. Thus the decline in total employment in Thailand and Malaysia was limited, and employment actually rose in Indonesia. Labor was reallocated from the formal (urban) sector to other activities, particularly the informal sector and agriculture, where exchange rate depreciations improved incentives.
Real public expenditures on education and health fell in the crisis countries, although efforts were made to increase spending on safety nets.
The extent to which households were able to adjust their spending to offset this decline varied across countries as well as income groups. In Thailand, families and government programs acted to cushion the impact of the crisis in order to avoid declines in school enrollment rates or in access to health services. In Indonesia, however, the severity of the crisis led to significant declines in poor households’ access to both education and health services, particularly in urban areas. Such setbacks can have irreversible effects on human development.
Even where public spending on safety nets increased significantly, the impact on poverty was limited for several reasons. These included the absence of safety nets before the crisis, response lags, institutional problems, and low levels of spending relative to the scale of poverty. In some cases, evidence suggests that well-functioning programs were under-funded relative to the potential impact of shocks on poverty.
Asian restructuring: from recovery to sustainable growth
The aftereffects of the externally triggered liquidity crisis in Korea, Indonesia, Thailand and Malaysia indiscriminately submerged both strong and weak producers and financiers. The rising tide is lifting the strong producers and financiers, but the financially weak continue to struggle on account of both crisis-induced and long-standing vulnerabilities.
Since the onset of the East Asian crisis more than two years ago, the corporate sectors and financial systems in the crisis economies have remained in severe distress. The banking systems’ nonperforming loans have skyrocketed to unprecedented levels: nonperforming loans range between approximately 30 percent of GDP for the Republic of Korea and Malaysia to 70 percent of GDP for Thailand. In contrast, nonperforming loans in other major emerging market crises (Chile in the early 1980s and Mexico in 1995) were less than 20 percent of GDP. In the Scandinavian banking crises during the early 1990s, nonperforming loans amounted to approximately 5 percent of GDP.
East Asia’s heavy reliance on bank-based financial systems and the high debt-equity ratios of corporations have made the economic distress especially acute. Weak firms in East Asia operated on thin margins in the years leading up to the crisis and their inability to pay interest following the onset of the crisis has added to their debt burden. Such firms constitute a significant portion of the corporate sector in each of the crisis economies, and the appetite to invest in them is extremely limited. They will continue to act as a drag on investment and growth until the financial claims on them are resolved, and either their operations return to adequate profitability or their assets are redeployed.
Without vigorous corporate and financial restructuring, the return to sustainable growth will likely take longer, the fiscal costs of the crisis could rise, and the economies will remain vulnerable to new external and internal shocks.
Recognizing the urgency, East Asian governments were quick to create an institutional structure for corporate and financial restructuring, and they also earmarked funds for bank recapitalization. The political momentum for reform has, however, slowed down, in part because the deeper structural problems now need to be addressed. Experience from other economies, including Japan, shows that a slackening of the reform effort can undo progress.
Government restructuring policies need to be guided by two principal considerations: limiting the likelihood of systemic disruption while also containing fiscal costs; and clarifying financial claims and building an environment conducive to asset reallocation. Based on these two principles, fiscal costs come principally from the government’s social contract to protect bank depositors and to prevent systemic failure. Government funds are not required for corporate restructuring.
Bank restructuring is important because it contributes to both policy objectives. Expeditiously restoring the health of the banking system is required, but the process of restructuring itself can be disruptive.
Restructuring is necessary because a poorly capitalized banking sector creates continued systemic risks and growing fiscal liabilities for governments. Healthy banks are also best positioned to enforce claims and to pursue corporate restructuring. But restructuring should be undertaken in a manner that ensures the integrity and the organizational capital of the financial system so that prudent lending to businesses and households may continue. Achieving this objective requires making difficult choices. Having provided implicit or explicit guarantees, governments can either move ahead rapidly by taking fiscal responsibility for the costs of the crisis, or they can encourage private resolution of the distress while applying regulatory forbearance. Waiting to resolve problems is likely to make them worse. However, expeditious and transparent action should be accompanied by market-based measures to recoup fiscal costs and to signal credibly a commitment to severely restrict guarantees and bailouts in the future.
Corporate restructuring needs to deal first with the delineation and allocation of losses.
Improvements in accounting standards and bankruptcy regimes can help support this process. However, in the absence of effective bankruptcy procedures, out-of-court procedures offer a mechanism for resolution. Once financial claims are resolved, corporate restructuring can be expected to occur through natural market forces, except where a major impediment prevents such forces from working. Governments can facilitate asset mobility by creating the framework for effective domestic and cross-border mergers and acquisitions. The Japanese experience cautions that, without an adequate infrastructure for resolving claims and for fostering asset mobility, fundamental corporate restructuring can be interminably deferred at a high economic cost even in a sophisticated economy.
Managing the recent commodity price cycle
Primary commodity prices have undergone a pronounced cycle since the mid-1990s, driven by both temporary and secular factors.
Primary commodity prices continue to be more volatile than the prices of manufactures. Energy prices were especially volatile. Crude oil prices rose 74 percent from early 1994 through the end of 1996, then fell 56 percent by the end of 1998, and in 1999 recovered nearly the entire decline of the previous two years. Average non-oil commodity prices rose by 46 percent from the monthly low in mid-1993 to mid-1997 and then dropped 30 percent by late 1999. The cycle in primary commodity prices was driven by changes in global demand, weather-related supply shocks, supply responses to the high prices of the early 1990s, technological innovations that have reduced production costs, and exchange rate depreciations among large commodity exporters linked to the Asian crisis.
Such volatility poses real challenges to developing countries that depend on primary commodities for a substantial share of their export revenues. Countries where consumption rises with real incomes during commodity price booms may face either painful reductions in consumption or declines in investment that reduce long-term growth when prices fall. Countries’ savings and investment behavior differed markedly over the recent commodity price cycle, and these differences primarily reflected the quality of policies rather than shifts in the terms of trade.
In the oil exporting countries, weak policy environments led to mixed savings performance and lower investment over the oil price cycle. On average, countries allocated to increased consumption about half of the average 5 percent of GDP improvement in real incomes during the upswing in oil prices (1996-97). During the 1998 drop in oil prices, however, consumption did not decline, implying that savings fell by the full amount of the decline in real incomes. Countries’ performance varied greatly, depending on their specific political and economic circumstances.
Oil exporting countries’ investment fell relative to output over the commodity price cycle. The decline in investment was actually greater than the decline in domestic savings, so the current account deficit fell. The major oil exporting countries have generally failed to reduce their dependence on oil revenues, and the fall in investment will further impede progress. At the same time, several of these countries face high levels of unemployment, continued slow growth, and rapidly expanding populations. They need to strengthen their policies to encourage greater private sector (and non-oil) activities and to improve the institutional environment.
The commodity price cycle of the 1990s does not appear to have adversely affected the prospects for growth in the non-oil exporting countries of Sub-Saharan Africa. Changes in real incomes were generally smaller than in the oil exporting countries because the price of their commodity exports changed by less than the price of oil, and the losses from declining export prices were partially offset by gains from lower import prices, particularly energy prices. More important, however, improvements in policies in several countries enabled them to increase savings and investment rates both during commodity price booms and busts. Many countries cut their fiscal deficits in an effort to rein in the growth of debt and to reduce inflation, while private savings rose in response to improved policies that increased the return to investment, particularly in export sectors. Countries with better policies, as measured by the World Bank, achieved larger increases in savings and higher growth of GDP than countries with worse policies, despite smaller increases in real incomes in the former group.
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