variables used in the analysis are GDP growth rate, GFCF as a share of GDP, XG&S as a share of GDP, current account balance (CAB) as a share of GDP, official exchange rate, foreign exchange reserves as a share of GDP, nominal interest rate, real interest rate and M1 money stock as a share of GDP.
Most of the data have been taken from the International Financial Statistics (IFS) Database of International Monetary Fund (IMF). The rest of the data have been downloaded from the World Bank Databank.
Literature Survey
The global financial crisis (GFC) was one of the major shocks which first affected the financial sector and slowly spread to the real economy in the US and then in the global economy. Unregulated sub-prime lending together with massive sale of securitised assets, legitimised by faulty credit ratings in the backdrop of easy liquidity situation created an asset price bubble. The bubble burst with the fall of the Lehman Brothers in September 2008. The US government’s initial reluctance to bail out the affected institutions led to one of the worst financial crises in the 21st century. One of the most important causes of the GFC can be attributed to unregulated financial institutions and practices, called the New Financial Architecture (NFA) (Crotty, 2008). As the crisis spread to developing countries, the governments implemented rescue packages and expansionary monetary policies to prevent the collapse of financial institutions. The situation was aggravated by uncertainty, collapse of commodity prices and weakening of global economic prospects, thereby creating pressures for currency depreciation. Thus, the accumulation of reserves was insufficient in repelling the negative consequences of the crisis (Dullien et al., 2010). Despite the availability of collateral, disruptions in unsecured markets affected secured markets. The interaction between the relative size of the banking sector, financial markets, and the economy plays a crucial role in risk sharing and how the economy is affected in case of a shock. If the banks have sufficient bonds, they have to borrow less in unsecured markets (Heider and Hoerova, 2009). The emerging markets were affected by external shocks primarily through two channels: decline in exports and terms of trade and decline in capital flows and in many cases significant outflows. The hypothesis that high reserves mitigate the probability of output losses in times of crisis is not supported by econometric analysis (Blanchard et al., 2010). Thus, adoption of appropriate macroeconomic policies and accumulation of foreign currency reserve were insufficient to immunise developing countries against such negative shocks (Dullien et al., 2010).
After the crisis, it was necessary to implement policies to restore confidence in the financial market and reverse the falling export demand. For this, several fiscal and monetary expansionary policies were used. There was a greater need to have access to finance, which was scarce at that time (World Bank and IMF Staff, 2009). Rodrik (2009) pointed out that for macroeconomic stability, external imbalances should not be allowed to become too large. However, markets were essential for developing country tradable goods to ensure their growth (policies like GSP by US). This appears to be contradictory in nature. He argued that there was a way to accommodate these apparently conflicting ideas by greater use of explicit industrial policies in developing countries. These policies should have the potential to encourage modern tradable activities while preventing surplus trade.
Global GDP growth declined to 2% after an average growth of 5% in 2003–2007. Emerging market economies were affected through trade and the financial market channels. There was a rapid rise in unemployment and output gaps (Calvo, 2010). These tended to increase deflationary pressures. There were sharp declines in funding available for sovereigns and corporations, leading to a steep rise in interest margins. Those countries whose banking sector relied heavily on foreign finance and had large current account (CA) deficits were affected the most by the crisis. Due to reduced access to external finance, banks started hoarding cash, thus increasing vulnerabilities. Thus, private financial flows to financial markets in developing countries declined, sharply reducing syndicated bank lending, portfolio flows and foreign direct investment (FDI) (World Bank and IMF Staff, 2009).
Tighter regulations in the advanced economies led to a scarcity of finance and credit in the developing countries. As credit declined, financial strains led to job losses and declines in income. Poverty increased and human development (which had been improving rapidly during the boom) suffered a setback. It was advised that Millennium Development Goals (MDGs) should be kept in mind while prescribing the policies for recovery. It was important for the countries to protect vulnerable groups in the short run and undertake investment and development goals in the long term (Griffith-Jones and Ocampo, 2009). The pace of progress in poverty reduction, improved healthcare and literacy in developing countries dropped. However, the social impact has been smaller in comparison to previous crises (Calvo, 2013). Because of the depth of the crisis and the need to thoroughly restructure the banking system, recovery was weak. Unsustainable fiscal deficits had to be cut without hampering recovery. At the same time, to prevent a new bubble creation, monetary expansion had to be regulated. There were efforts to strengthen the domestic financial system and expand regional cooperation (World Bank, 2010).
The following were the main channels through which the crisis affected developing countries: banking failures and domestic lending reductions, reduction in earnings from exports and reduction of financial and capital flows (Naude, 2009).
The liquidity boom following expansionary monetary policies followed to counter the effects of the crisis increased investment in developing countries and expanded the supply potential rapidly. However, output remained low and capital output ratios in developing countries became significantly higher. Expansion in domestic credit led to an increase in consumption and raised external imbalances. This gave rise to unstable macroeconomic conditions. Countries with more liberalised, regulated institutional frameworks and good investment opportunities attracted more capital flows in the boom period. Countries with resources also attracted capital flows as the resources acted as secure collateral — compensation in the absence of a strong institutional framework. Thus, external savings was an important source of finance (World Bank, 2010).
Sustainable recovery depends on maintaining internal balance and external balance. Internal balancing is the strengthening of private demand in advanced economies, paving the way for a fiscal consolidation. External balancing is increasing the trade balance in deficit countries and decreasing the trade balance in surplus countries. If the developing countries face strong domestic demand, then growth can be sustained even in times of lower import demand from the world markets. Thus, the need was to develop growth paths while allowing for more exchange rate flexibility. In these economies, increased investment stimulated by expansionary policies helped increase employment and consumption (IMF, 2010).
Just after the emergence of the crisis, there was a popular conjecture that the emerging Asian countries — India and China — might overtake US and Europe in the position they have in the world. However, through channels of trade and finance, these countries were affected by the GFC and thus the conjecture turned out to be false. Though GDP did not decline because of the crisis, the growth rate slowed. It is said that Asia is converging rapidly. As Asia is large and diverse, a single analysis and policy prescription will not suffice for its growth. These countries generally had high savings rates. In the post-crisis periods, these savings rates increased, especially in those countries affected by the crisis (Chhibber et al., 2009). Countries with low reserves and high CA deficits were hardest hit by the crisis. Thus, strengthening South–South financial flows could secure a sustainable FDI flow into the developing world. Developing countries’ risk premiums have now fallen. The tremendous growth potential of domestic saving in developing countries can be captured through increasing domestic intermediation. The only threat is that of recession, which can cause reduction of funds from the donors (World Bank and IMF Staff, 2009). The governments of these countries had a very large role to play in adjusting investments through fiscal policies. The Chinese economic expansion assumed greater significance after the Asian crisis and the GFC. The impact of the GFC was felt more in the real economy than in the Chinese financial market (Dullien et al., 2010). China’s increasingly diversified export basket supported many
