WASHINGTON, December 2, 1998 — Developing countries will be hardest hit by the economic and social costs of global slowdown in 1998-2000, with their per capita growth expected to slow to 0.4 percent in 1998, compared with 3.2 percent last year, according to a new World Bank report released today.

Brazil, Indonesia, Russia, and 33 other developing and transition countries—which between them account for 42 percent of total GDP for the developing world, and more than a quarter of its population—are likely to see negative per capita growth this year. In 1997, by comparison, per capita income fell in 21 countries which accounted for 10 percent of the developing world's GDP and 7 percent of its population. Although 1999 is likely to be another year of slow growth in developing countries, their situation could improve in 2000, and following years, when their per capita growth could return to the 3.5 percent pace of recent years (excluding transition economies).

According to the Bank's new report, Global Economic Prospects and the Developing Countries 1998/99, much of the slowdown in developing economies is due to the unprecedented depth and severity of the recession in the crisis countries of East Asia and its contagion effect on the rest of the world. With output projected to decline sharply in the region this year, and to stabilize in 1999, the report says that the Asian crisis already ranks with the Latin American debt crisis of the 1980's in terms of its impact on countries during its first 12 months.

"What many expected to be no more than a slight blip has instead become at destabilizing factor in the global economy," says Joseph E. Stiglitz, World Bank Senior Vice President and Chief Economist. "While 1998 and 1999 will be very difficult years for developing countries, in the longer term (2001-2007), growth in developing countries could still reach the record setting rates that we saw in 1991-97. But this will only happen if policies to prevent a deeper global slump are implemented quickly and developing countries strengthen their financial sectors."

Developing countries have been hurt by Japan's deepening home-grown recession, as well as by a series of shocks related to the Asian crisis. These include: the collapse of the Russian ruble, falling commodity prices, a marked slowdown in world import demand, and general risk aversion in financial markets. On top of this, El Niño-related phenomena brought both severe flooding and drought to many parts of Africa, Asia, and Latin America, devastating crops, water supplies, and rural infrastructure.

Largely because of these shocks, domestic demand this year is contracting in countries representing some 25 percent of world demand - large parts of developing East Asia, Japan, Russia, and the Middle East. In countries producing 70 percent of world output - mainly the United States and Europe - this demand is either cooling, or in the case of Latin America, slowing sharply.

In recent weeks, a number of powerful policy steps have been taken that are likely to foster world economic recovery in the medium-term. These include: recent successive interest rate cuts in the United States, and several countries in Europe; the Japanese Diet's approval of a fiscal stimulus and financial revitalization package; the declaration by G-7 leaders to support a strengthened global financial system, including support for IMF funding; agreement on an internal Brazilian fiscal package and the extension of a precautionary line-of-credit by the international community; a Japanese-led $30  billion assistance package in Asia; and the announcement at the recent APEC summit in Malaysia that the US, Japan, and multilateral institutions such as the World Bank, will be offering enhanced financial and social support to Asia's crisis countries.

While these policy steps are vitally important, the short-term outlook for developing countries remains precarious, especially since financing available to emerging markets has declined sharply since mid-August. In addition to presenting the most likely "baseline" forecast, the report outlines a low-case scenario which explores the consequence of spreading financial contagion in emerging markets, a deeper recession in Japan, and large stock market corrections in the United States and Europe. In the low-case scenario, the world economy experiences a severe recession in 1999, and per capita growth in developing countries as a group (excluding transition economies) declines for the first time since 1981-82.

Dealing with crises: a case of tough lessons

In addition to forecasting growth rates for developing countries, Global Economic Prospects 1998/99 also focuses on two leading questions: why did the crisis have such a damaging impact, even in countries with relatively sound economies? And, how can the international community prevent future crises ?

"This was not the usual government borrowing crisis that we had become familiar with over the years and knew how to fix," says Uri Dadush, Director of the World Bank's Development Prospects Group, which produces the report. "Looking forward, the primary role of fiscal and, where possible, monetary policy now is to shore up demand, expand the social safety net, and re-capitalize financial systems. Restructuring corporations lies at the heart of a sustained recovery and continuing financial support from the international community is vital."

Accordingly, the World Bank is adopting a twin-track approach which, first, focuses on restructuring financial and corporate sectors; and second, on social protection for the poor and other vulnerable groups during crises.

Financial and corporate restructuring and reform

By the middle of 1998, large parts of the private corporate and financial sectors in the five crisis countries were either insolvent or suffering severe distress. In Indonesia, Korea, Malaysia, and Thailand, non-performing loans are thought to be so extensive that writing them off against bank capital would result in negative net worth in the banking system.

Re-capitalizing banking systems to reach the 8 percent capital adequacy ratios recommended by the Bank of International Settlement (BIS) would cost an estimated 20 to 30 percent of GDP in these countries.

Therefore, to secure economic recovery, policymakers need to undertake the unusually long, complex, and arduous task of nursing these sectors back to health, as well as strengthening institutions of prudential supervision, regulation, and governance that would reduce the likelihood of such crises in the future.

Given the systemic nature of this crisis, financial restructuring will require strong government leadership within a clear strategic framework, including, inevitably, the injection of substantial public funds. Restoring viable corporations to health will mean restructuring their often gigantic domestic and foreign debts, by rescheduling, writing down, or converting their debt to equity. The involvement of foreign investors, who can provide new equity and risk capital, will be important for both financial and corporate restructuring. There is also much that OECD governments can do to speed the resolution of debt overhang, especially with external private creditors.

The need for resolution of domestic debt problems is equally compelling if economies are to move ahead. However, restructuring on the scale needed in East Asia is relatively unexplored territory and new approaches may well be required.

Social impact of the crisis was not appreciated early enough

Global Economic Prospects 1998/99 says that the conventional response to the East Asia crisis also failed to recognize its profound social cost and, in particular, along with drought and soaring prices for staple foods in some countries, its disproportionate impact on the poor. Although East Asian countries had reduced poverty and boosted living standards at a pace unrivalled in history, cross-country research shows that protracted crises produce more poverty, greater income inequality, and deteriorating social indicators such as malnutrition that have serious long-term consequences. In Indonesia, South Korea, and Thailand, unemployment is expected to more than triple, while the number of people falling back into poverty in 1998 could reach 25 million in Indonesia and Thailand alone, and could be much higher if income inequality rises.

"The crisis has revealed just how little social protection there was for the poor in East Asia once the regional economy ran into serious trouble," says Dipak Dasgupta, the lead author of the report and Principal Economist at the World Bank. "Looking ahead, it's clear that social policy concerns need to be center-stage along with fiscal and monetary priorities when devising the right response to economic crises. While they're never a substitute for sound, pro-growth economic policies, social safety nets can also help cushion the worst effects of the crisis on the poor and other vulnerable groups."

The reports says that priority actions to protect the poor in a crisis - which are central to World Bank social lending to East Asia - should include ensuring food supplies through direct transfers and subsidies, generating income for the poor through cash grants and public works, preserving people's physical well-being through basic health care and education services, and increasing training and job search assistance for the unemployed. Building social safety nets prior to a crisis is another priority.

Preventing Future Crises

Having carefully analyzed the origins of, and the policy response to, the East Asia crisis, Global Economic Prospects 1998/99 argues that the age of large-scale private capital flows presents developing countries with complex problems in managing these flows safely.

The central issue is that developing countries have little experience with the institutional and regulatory safeguards needed to use world capital markets effectively, and these take a long time to develop, even in countries with the necessary skills and an effective civil service. In contrast, industrial countries have adopted public policy and institutional reforms over the past one hundred years to prevent systemic crises. And they appear to have reduced the incidence and severity of crises, but not eliminated them (take for example, the savings and loan crisis in the United States in the 1980's; banking crises in the Nordic countries in the early 1990's; and the massive financial distress in Japan today).

The report highlights the interaction of the many factors that amplify the risks of financial crises in developing countries, including: fragile domestic financial systems, unsound macroeconomic policies, poorly-prepared financial or capital-account liberalization (or both), weak corporate governance, and the tendency of international capital markets to vacillate between euphoria and panic. The World Bank recommends several measures which, based on the lessons of East Asia, it believes could limit future crises.

• A more comprehensive approach is needed when trying to deal with excessive private borrowing and risk-taking in the presence of large capital inflows and weak financial systems. This often means applying more flexible exchange rates, tighter fiscal policy, improved and tighter financial regulation (and, where necessary, restrictions on capital flows). These measures will tend to reduce overly large capital inflows, and the domestic lending booms that usually precede financial crises.
• Domestic financial sector liberalization - which can greatly increase the risks of crisis (particularly in conjunction with open capital accounts) should proceed carefully, and in step with tighter financial regulation and supervision.
• Capital account liberalization should also proceed cautiously. It is unrealistic to expect the best policies and strongest institutions to prevail in developing countries and, therefore, eliminate the risks of crisis.

  "Liberalization of a country's domestic financial system as well as its capital account should be pursued, but the appropriate timing and sequencing of these reforms is crucial for minimizing the risks of crisis," says Mustapha Nabli, a Senior Economic Adviser at the World Bank and a former Tunisian minister for economic development (1990-95). "The lesson coming out of the East Asia crisis is for developing countries to strengthen their institutions and deepen their reforms so as to benefit from globalization, and not to retreat from it."

• Changes are needed to the global economic architecture in view of the excessive volatility of short-term debt flows, strong contagion effects of crisis, and increased moral hazard in international financial markets. However, the report warns that this will be a long-term process of reform and underlines that its guiding principles are already being earnestly debated at many levels of the international community. Given the importance of these issues, it is vital that this debate be conducted frankly and openly and reflect broad opinion.

Conclusions

The report strikes a note of optimism, suggesting that events over the past 12 months may well herald a new, more realistic and stable environment for developing countries. In particular, there are many positive features of the world economy that should support strong long-term growth, such as: more open and competitive markets and strong growth in world trade; the impressive increase in foreign direct investment which hit another record in 1998 despite the crisis; low international inflation rates and lower fiscal deficits; and more than a decade of solid market-orientated economic reforms in developing countries. The benefits of greater openness in trade are among the more important ways in which countries can still achieve faster long-term growth. Similarly, the benefits of openness to foreign direct investment are considerable - in providing improved access to markets, better technologies and productivity, and more advanced skills.

Developing countries can also benefit from other long-term capital flows from world financial markets; for that to happen, domestic bond and capital markets need to become more sophisticated.

This crisis, while its economic and social impact has been severe, has also produced important lessons in fortifying the global economy and thereby preventing future crises of this magnitude. Countries need to build and strengthen regulatory and institutional structures to ensure safe and stable financial systems, especially where they relate to the international financial markets; and the international financial architecture, in order to prevent crises and deal with them more effectively, must be modified to allow greater numbers of countries to enjoy more of the real benefits of the new global economy while reducing their exposure to its risks.