1 Global Economic Crisis: What Can Small Open Economies Do? Asad Alam The World Bank AIPRG Conference, Yerevan July 7, 2009

What does history teach us? Economic contractions that follow financial crises are longer and deeper than contractions that do not (Reinhart, Rogoff) Such contractions tend to have significant adverse consequences on government finances (deficit and debt) Unemployment consequences of such contractions are also usually larger than for downturns without major financial stress Swift policy responses are critical – additional financing is helpful but adjustment is almost always needed. 2

Recovery is likely to be slow and hesitant Large fiscal stimulus of big economies, especially US and China, will help; but recovery will be slow Return to pre-crisis status-quo is not a sustainable solution for global economy: the long-term solution is in addressing global imbalances, i.e. increase in US saving rates The past drivers of growth in emerging markets will likely be weaker as private capital will be scarcer and more discriminating, and export growth slower A second wave of financial turbulence is possible if quality of banking sector loans deteriorate substantially: this will further suppress global capital flows and delay their recovery 3

Small open economies gained heavily from global growth and integration but are exposed to global shocks Small open economies gained from key transmission channels: Trade FDI Remittances Rising ToT Foreign credit But the same channels are now transmitting global shocks to their shores 4

All economies are hit but impact is differentiated according to fundamentals External balance, role of external financing, rollover needs Fiscal balance, whether sufficient fiscal space exists Health of the financial sector (quality of loan books, open exchange rate positions) How narrow is production and export base Structural rigidities (in goods and factor markets) Size of domestic market Exposure to different transmission channels 5

Policy responses Fiscal stimulus through own resources (fiscal space permitting) and/or leveraging donors inflows Protect the poor and the vulnerable through scaling up targeted SSN, within limits of affordability External (exchange rate) adjustment as a response to changed external environment Fiscal adjustments (lower expenditures or higher taxes) as revenues collapse and countercyclical expenditure needs rise Enhanced financial sector support and regulatory strengthening 6

7 lessons for small open economies 1. Initial conditions matter MAINTAIN STRONG MACRO FUNDAMENTALS 2. Global volatility is going to be normal in an integrated world DEVELOP MACRO RISK MANAGEMENT SYSTEMS 3. Smart countercyclical policies can help create jobs in the short term and strengthen competitiveness in the medium term BE PROACTIVE 4. Recovery will be slow and more prolonged than in larger markets PLAN FOR THE MEDIUM-TERM 5. Balance between financing and adjustment has to be found EXTERNAL ADJUSTMENT AND MEDIUM-TERM FISCAL CONSOLIDATION IS INEVITABLE 6. Even with properly manager public finances, the fight against poverty will be set back SCALE UP EFFECTIVE ANTI-POVERTY PROGRAMS 7. External resources will continue to be scarce specially in the post-crisis world STRENGTHENING COMPETITIVENESS AND ECONOMIC DIVERSIFICATION IS KEY 7