The Financial Crisis and Debt: Challenges for Developing Countries

1

Carlos A. Primo BragaDirector, PRMED

MDB Meeting on Debt IssuesJuly 2009

A Perfect Storm

Presentation outline The financial crisis in a nutshell

Policy reactions

Implications for industrialized and emerging economies: the debt challenge

Debt sustainability and the crisis: implications for LICs

The importance of debt management

3

The financial crisis will cause a sharp decline in global growth: the largest since the 1930s

Source: DEC Prospects Group.

The crisis in a nutshell

Antecedents of the crisis:Boom-bust credit boom, fueled by lax

monetary policy in developed countries

An asset price bubble and excess investment in real estate (poor assessment of risks)

Poor corporate governance

Macroeconomic imbalances

5

Additional considerations

Financial innovation and increased opaqueness -- Reckless use of collateralized debt obligations -- Growing reliance on the originate-to-distribute business model/poorer risk assignment

Financial integration-- Much larger capital flows /cross-border positions

Major regulatory and supervision changes-- The repeal of Glass Steagall (1999) to allow US conglomerates to

leverage their balance sheets like EU universal banks; transition from Basel I to Basel II; SEC ruling on net capital (2004)…

Residential mortgage backed securities versus other securitized assets

Source: Blundell-Wignall and Atkinson (2008), Federal Reserve, Datasteam, OECD.

(% GDP USA)

The crisis in a nutshell

Developing Countries: Main Transmission

Channels

• Financial sector effects impact on “domestic” financial sector and

“sophisticated” firms

• Liquidity squeeze and lower risk appetite higher financial costs

• Lower commodity prices and trade volumes lower export proceeds and

government revenues

• Reduction in capital flows and remittances tightened financial sources

8

Economic shocks and the world trading system

• The food and fuel price surges led to disorderly and sometimes harmful trade policy responses

• Financial crisis has led to a trade credit crunch and sharp increases in credit spreads

0

50

100

150

200

250

2003 2004 2005 2006 2007 2008 est

Trade credit spreads (bp)

Brazil Indonesia

Korea China

India Russia

Turkey

Trade credit spreads (bp)

Source: Data collected by WB staff from private sources.

• Contraction in trade finance was also fostered by loss of critical market participants

• Secondary market drying up, reducing ability of banks to sell trade finance positions

• Concerns about protectionist measures rising

• World trade volume (goods and services) is likely to contract by more than 6% in 2009

Some good news: pace of decline in trade is easing

goods exports, nominal, qtr/qtr ch% (saar)

Developing Countries

Source: Thomson/Datastream

But all types of private capital flows to emerging economies are plunging

U.S. dollars, billions, net 2006 2007 2008 2009

Private Flows 565 929 466 165

• Equity investment 222 296 174 195

• Direct 171 304 263 198

• Portfolio 52 -8 -89 -3

• Private Creditors 343 632 292 -30

• Commercial Banks 212 410 167 -61

• Nonbanks 131 222 125 31

Official Flows, net -58 11 41 29

• IFIs -30 3 17 31

• Bilateral -27 9 24 -2

Source: Institute for International Finance: “Capital Flows to Emerging Market Economies.” 01/27/09.

-100

100

300

500

700

900

1100

1300

1500

2000 2002 2004 2006 2008e

-1

1

3

5

7

9$ billions

Debt

Port Equity

FDI inflows

Changing composition of private capital flows to developing countries

(Source: DECPG/GDF 2009)

Percent of GDP (right axis)Percent of GDP (right axis)

percent

Relative to past downturns the decline of capital flows has been even more

dramatic

Percent

1980-83 1997-02

Projection2007-10

Net private capital flows / GDP in developing countries

Source: DECPG/GDF 2009

External Debt Refinancing Needs ($ billions)

0

100

200

300

400

500

600

700

800

900

1000

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12 0%

5%

10%

15%

20%

25%

Sovereign and

Corporate

Corporate

Sovereign

As a percentof U.S. dollar GDP

(right scale)

Asia Emerging Europe Latin America

Corporate rollover needs are massive

Source: IMF

Over $1.5 trillion in rollover needs for 2009, with the private sector holding the lion’s share

14

Potential declines inremittances and ODA

Source: World Bank data and staff estimates.

Remittance Flows to Developing Countries Official Development Assistance

(% of GDP)(USD, % Change)

Policy reactions to the crisis

At country level:Monetary easingRecapitalization of financial systemsBailout of household and corporate

sectorsFiscal stimulus packages Financial systems regulatory overhaul

And IFIs are intermediating more funds than ever

16

G20 countries – fiscal stimulus and financial sector support

17

1/ In percent of 2009 GDP. Excludes below-the-line operations that involve acquisition of assets.

2/ As of Apr. 15, 2009, in percent of 2008 GDP. Consists of capital injection, purchase of assets and lending by Treasury, and central bank support provided with Treasury backing.Source: IMF

Advanced economies: Average discretionary fiscal expansion in 2009: 1.5% of GDPAverage financial sector support: 5.4% of 2008 GDP

Emerging economies:Average discretionary fiscal expansion in 2009: 2.0% of GDP

Central Bank balance sheets in advanced economies have been rapidly expanding

Central Banks’ Total Assets (Index, 12/29/06 = 100)

18

Collapse of Lehman Brothers

UK

US

Euro Area

Japan

Source: IMF WEO (2009)

Government Debt: medium term prospects

Significant expansion of public debt in advanced economiesDebt/GDP Ratios (Source: WEO, 2009)

19

2007 2009 2014

Advanced G20

77.6 97.7 114.1

Emerging G20

37.8 38.7 35.0

USA 63.1 87.0 106.7

Japan 187.7 217.2 234.2

UK 44.1 62.7 87.8

Korea 33.0 40.0 51.8

Brazil 67.7 65.4 54.1

China 20.2 19.8 17.9

India 80.4 86.8 76.8

Government Debt: medium and long term challenges

Macro considerations: evolution of the dollar and interest rates, as well as the future of export-led models of development;

The importance of preserving long-term growth potential (the composition of current fiscal packages);

Growing aging-related budgetary pressures (fiscal costs likely to increase more than 10 % of GDP in the next 40 years in Korea and more than 5% of GDP in countries such as Canada and Spain…)

20

Debt sustainability prospects in LICs

Debt sustainability indicators will deteriorate due to the fall in exports and government revenues, and the increase in debt service;

For some countries rollover and accelerated repayment may be an issue;

Debt sustainability indicators may deteriorate even further as governments implement fiscal stimulus packages.

21

IDA-only countries

Risk of debt distress (FY10 grant allocation)

HIPCs

In the case of IDA, the graph reflects only countries for which a DSA is available. The graph for HIPCs includes: Bolivia and Honduras (both Blend countries) and Somalia (for which a DSA is not available)

(as of end June 2009)

HIPCs: recent progress and current status

Debt sustainability prospects

A critical issue is how long the crisis will last.

A short lived crisis will have a small effect on debt sustainability as relevant analysis is of a long term nature (e.g., the Debt Sustainability Analysis is forward looking, 20 yrs);

In contrast, a protracted crisis will have a more lasting effect on debt sustainability.

24

Debt sustainability and the crisis

25

YEAR

1 2 3 4 5 6 7

(A) Exports: % deviation with respect to baseline

30 25 20 15 10 5 0

20 10 0 0 0 0 0

(B) Conditions of additional financing incurred to maintain consumption and expenditures constant

(i) IDA terms: 40 yrs; 10 yrs grace period; 0.75% interest

(ii) Commercial: 10 yrs.; no grace period; 5% interest

Two scenarios/shocks with different financing conditions

Debt sustainability and the crisis

26

Debt sustainability and the crisis

27

A protracted crisis?

31

Recessions

46 10

3

18

9

4

1

Credit Crunches

HousePrice Busts

EquityPrice Busts

31

Source: Claessens, Kose, Terrones (2008)

Recessions, Crunches, and Busts Output Trajectory During U.S. Recessions

• Current crisis is one of four of the past 122 recession to include a credit crunch, housing price bust, and equity price bust

• Average of past US recessions has shown that it has taken 5-6 quarters before pre-recession output levels were regained; current recovery will take longer

28

Source: JP Morgan

Debt management and the crisis

29

While a debt sustainability analysis focuses on the long-term sustainability of debt, which is influenced by both its level and composition, a debt management framework focuses on how the composition of debt is managed.

The crisis creates particular challenges for debt managers:

How to close an increasing financing gap and finance a country’s development needs at low cost with a prudent degree of risk, especially at a time when conditions in financial markets are severely constrained?

Given limited external financing options, how can potential benefits from developing domestic markets be exploited at a low cost and prudent degree of risk?

Given the efforts by many governments to strengthen their balance sheets over the past decade, how can these sounder public debt structures be protected?

Since the crisis implies substantial macroeconomic adjustments, how should debt management strategy reflect the new reality?

Systematic application of the Debt Management Performance Assessment (DeMPA)

Country-led design of medium-term debt management strategies (MTDS) jointly with the IMF

Design of reform programs

Training events

Research and development of knowledge products

Peer learning initiatives, such as a the Debt Management Practitioners’ Program and the Debt Managers Network

The Debt Management Facility (a network of TA providers)

DeMPA results indicate that only 4 out of 27 assessed countries had a satisfactory

medium-term strategy in place

Financial crisis: scale of policy responses is country specific, but, given the procyclicality of the financial system, it is important to coordinate financial sector reform and to synchronize macroeconomic responses;

The severity of the downturn highlights the need for an increase in high-impact fiscal expenditures. But embedding stimulus packages in a credible medium-term strategy, that safeguards fiscal sustainability, is key;

Expansion of public debt will be massive. Countries need to design exit strategies to the ongoing fiscal interventions and to introduce growth-enhancing reforms to reassure markets of the public sector’s solvency. Needless to say, coordination of exit strategies pose major challenges. The challenges are even greater for those facing significant fiscal pressures associated with aging-related spending;

Debt sustainability implications for LICs: a function of the crisis duration. The role and the impact of non-concessional borrowing needs to be carefully evaluated;

Debt management: the crisis further underscores the importance of debt management practices and makes the Debt Management Facility even more relevant;

Concluding remarks

WBG response: increase in IBRD lending (mix of Development Policy Loans (budget financing/fast disbursing: financial sector restructuring; contingent source of liquidity...) and Investment Loans (preserving infrastructure spending; support for clean technology; social safety nets...)); fast-tracking IDA funds; Vulnerability Financing Facility; INFRA (support for infrastructure); guarantees via MIGA; new IFC facilities (support for trade; recapitalization of banks; refinancing of microcredit institutions).

World Bank Group Commitments fiscal years 2009 and 2008 (in U.S. billions)

World Bank Group FY09* FY08• IBRD 32.9 13.5• IDA 14.0 11.2• IFC 10.5+ 11.4+

• MIGA 1.4 2.1TOTAL 58.8 38.2

*Unaudited numbers as of July 1.+Own account only. Excludes $4.5 billion in FY09 and $4.8 billion in FY08

mobilized through syndications and structured finance.

Concluding remarks (cont.)