Developing Economies Shrink
World Economy

Developing Economies Shrink

After a series of crises with severe economic and social consequences in the 1990s and early 2000s, emerging and developing economies have become even more closely integrated into what is widely recognized as an inherently unstable international financial system.
Both policies in these countries and a highly accommodating global financial environment have played a role. Not only have their traditional cross-border linkages been deepened and external balance sheets expanded rapidly, but also foreign presence in their domestic credit, bond, equity and property markets has reached unprecedented levels, IPS’s columnist Yilmaz Akyuz opined.
New channels have thus emerged for the transmission of financial shocks from global boom-bust cycles.
Almost all developing countries are now vulnerable, irrespective of their balance-of-payments, external debt, net foreign assets and international reserve positions, although these play an important role in the way such shocks could affect them.
Stability of domestic banking and asset markets is susceptible even in countries with strong external positions.
Those heavily dependent on foreign capital are prone to liquidity and solvency crises as well as domestic financial turmoil.

  No Proper Buffer
The new practices adopted in recent years – including more flexible exchange rate regimes, accumulation of large stocks of international reserves or borrowing in local currency – would not provide much of a buffer against severe external shocks such as those that may result from the normalization of monetary policy in the United States.
And the multilateral system is still lacking adequate mechanisms for an orderly and equitable resolution of external financial instability and crises in developing economies.
This process of closer integration was greatly helped by highly favorable global financial conditions before 2008, thanks to the very same credit and spending bubbles that culminated in a severe crisis in the United States and Europe.

  New Vulnerabilities
The surge in capital inflows that started in the early years of the new millennium, and continued with full force after a temporary blip due to the collapse in 2008 of the Lehman Brothers financial services firm, holds the key to the growing internationalization of finance in developing countries.
It has resulted in a rapid expansion of gross external assets and liabilities of developing economies. More importantly, the structure of their external balance sheets has undergone important changes, particularly on the liabilities side, bringing new vulnerabilities.
The share of direct and portfolio equity in external liabilities has been increasing. While still remaining below the levels seen a decade ago as a percentage of gross domestic product (GDP), external debt build-up has accelerated since the crisis in 2008.

  Cross-Border Lending
As a result of a shift of governments from international to domestic bond markets and opening them to foreigners, the participation of non-residents in these markets has been growing. The proportion of local-currency sovereign debt held abroad is greater in many developing countries than in reserve-issuers such as the United States, Britain and Japan. It is held by fickle investors rather than by foreign central banks as international reserves.
International banks have been shifting from cross-border lending to local lending by establishing commercial presence in developing countries. Their market share in these countries has reached 50 percent compared with 20 percent in developed countries.
One of the key lessons of history of economic development is that successful policies are associated not with full integration into the global economy, but strategic integration seeking to use the opportunities that a broader economic space may offer while minimising the potential risks it may entail. This is more so in finance than in trade, investment and technology.
For one thing, the international financial system is inherently unstable in large part because multilateral arrangements fail to impose adequate discipline over financial markets and policies in systemically important countries which exert a disproportionately large impact on global conditions.


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