Dr. Julius Muia, Public Sector Lead at Andersen Consulting and Board Member of the International Centre for Evaluation and Development (ICED), delivered a presentation on the topic of "Current Financial Shocks and Development Visions of Developing Countries" at the 6th Evidence to Action (E2A) Conference and Exhibition. The conference took place from 24th to 28th July 2023 in Addis Ababa, Ethiopia.
Dr. Julius Muia
In his presentation, Dr. Muia began by defining financial shocks as unexpected disturbances that originate from the financial sector and have a significant effect on an economy, such as a national, regional, or global economy. He explained that financial shocks are often triggered by different sources of risk, which can be either inside or outside the financial system and are often amplified by adverse macro-financial feedback effects. Dr. Muia outlined four factors that can typically cause financial instability, including changes in interest rates, deterioration in bank balance sheets, negative shocks to non-bank balance sheets, such as a stock market decline, and increases in uncertainty.
Dr. Julius Muia
Dr. Muia then discussed different types of financial crises, such as a liquidity crisis in the financial market, a currency crisis, and an unexpected stock market crash. He explained that financial crises occur when asset prices drop steeply, businesses and consumers cannot pay their debts, and financial institutions experience liquidity shortages. He also outlined the three stages of a financial crisis, which include failures in the financial system and regulatory failures, institutional mismanagement of finances, and obligations.
Dr. Muia provided examples of historical financial crises, such as the Tulip Mania of 1637, the Credit Crisis of 1772, the Stock Crash of 1929, the OPEC Oil Crisis of 1973, and the Global Financial Crisis of 2007-2008. He also discussed the effects of financial crises, such as reduced GDP growth per capita and investment, increased debts by institutions and households leading to default, reduced entrepreneurship and business dynamism, and increased unemployment.
Dr. Muia distinguished between financial crises and economic crises, explaining that financial crises affect the financial and banking sector, deepen economic downturns, trigger capital flight, and undermine monetary policy, while economic crises affect all economic activities in the economy, causing inflation and spurring unemployment. He outlined contributing factors to each type of crisis and discussed different types of shocks that can affect an economy, such as supply shocks, demand shocks, financial shocks, policy shocks, and technology shocks.
Dr. Muia echoed the need for resilience in the face of financial shocks and other challenges facing vulnerable populations in developing countries. He defined resilience as the ability of a system or community to survive disruption and to anticipate, adapt, and flourish in the face of change. He quoted the Food and Agriculture Organization (FAO) and the United Nations Department of Economic and Social Affairs (UNDESA) in emphasizing the importance of resilience in policy and program development. Dr. Muia also cited comments by World Bank Group President David Malpass on the crisis facing development and the need for emerging and developing countries to navigate slow growth and heavy debt burdens in order to achieve the Sustainable Development Goals by 2030.
According to Julius Muia, there are several current economic shocks impacting developing countries. The first shock is the COVID-19 pandemic, which has had a significant impact on the global economy. Although its effects are fading, the legacy impact of COVID-19 still remains as countries are undergoing economic recovery. The containment and mitigation measures put in place to curb the spread of the virus adversely impacted the global economy, causing disruption of global supply chains, a decline in global output, and significant job losses. Fiscal performance was also adversely affected by a slowdown in economic activities and increased demands to finance COVID-19-related expenditures.
Another shock is the Russian-Ukraine conflict, which has disrupted the oil and commodity supply in the world and resulted in higher prices of oil products and other commodities, leading to a sharp increase in the cost of living. Rising inflation is also a major shock, with global overall inflation remaining elevated and increasing from 2.4% in 2019 to 8.3% in 2022. In Africa, average inflation increased from 12.9% in 2021 to an estimated 14.2% in 2022 and is estimated to rise to 15.1% in 2023 and later fall to 9.5% in 2024, benefiting from tightening of monetary policy and easing of domestic supply constraints. Continued supply chain disruptions and higher fuel prices reflecting elevated international oil prices have pushed prices up, while unfavorable weather conditions due to climate change have led to higher food prices. Several economies, including the US, UK, and France, have revised their monetary policies to curb the rise in inflation through monetary tightening.
The global monetary tightening due to tightening of the monetary policy to keep inflation expectations anchored has led to substantial increases in interest rates and expensive borrowing, reducing market access for finances. Leading central banks have tightened their monetary policy aggressively, with South Africa raising its benchmark repo rate 10th consecutive time to 8.25% in May 2023 and Kenya consistently raising the Central Bank Rate from 7.5% in May 2022 to 10.5% in June 2023. Depreciation of currencies against the US dollar is another shock, with exchange rate fluctuations continuing in most countries, and domestic currencies in African net commodity exporters losing substantial value against the US dollar due to interest rate hikes in the United States. Most African countries are net importers of goods and services, leading to expensive imports, which further leads to an increase in prices and worsening current account balances.
Limited fiscal buffers to absorb shocks amid historically high debt levels is another shock, with public debt as a ratio to GDP soaring across the world during COVID-19 and expected to remain elevated. The high cost of debt servicing in the midst of global monetary tightening is increasing vulnerabilities, while financing conditions have tightened sharply amid high levels of private and public debt, pushing up debt servicing costs, constraining fiscal space, and increasing sovereign credit risks. Persistence drought conditions and vulnerability to climate-related risks is another shock, with the greater Horn of Africa suffering from its longest drought in four decades, leading to food insecurity for 36 million people across the region (Kenya, Somalia, Ethiopia), and the region's agriculture sector being largely affected.
To mitigate the impacts of these economic shocks, measures need to be put in place. The current crises are hitting the most vulnerable the hardest - often through no fault of their own.
According to the study, to avert human suffering and support an inclusive and sustainable future for all, governments may consider taking the following mitigation measures: subjecting financial institutions to both micro-prudential and macro-prudential supervision, strengthening the monetary policy framework to achieve a low and more stable inflation and inflation expectation, maintaining adequate international reserves to mitigate currency volatility, reducing the risks of currency mismatch and volatile capital outflows, avoiding fiscal austerity which would stifle growth and disproportionately affect the most vulnerable groups, affecting progress in gender equality, and development prospects across generations, ensuring economic development plans are realistic and balanced, reallocating and reprioritizing public expenditures through direct policy interventions that will create jobs and reinvigorate growth, strengthening social protection systems, ensuring continued support through targeted and temporary subsidies, cash transfers, and discounts on utility bills, which can be complemented with reductions in consumption taxes or custom duties, and making strategic public investments in education, health, digital infrastructure, new technologies, and climate change mitigation and adaptation that can offer large social returns, accelerate productivity growth, and strengthen resilience to economic, social, and environmental shocks.
The study also emphasizes that developing economies suffer the most from the occurrence of financial and economic shocks/crises. Therefore, developing countries need to design targeted policies aimed at driving economic growth, reducing poverty and inequality, and creating adequate jobs to build resilience to shocks. Additionally, their development visions need to clearly outline strategic policies and programs that not only deal with such shocks when they occur but also foster prevention and reduce the risks of shocks ex-ante.
The study also defines Development Visions as long-range development thinking that outlines the broad strategic vision for the country or region and implemented through medium-term development plans, which are four to five-year plans. These visions are accompanied by development planning, which involves the identification of the strategies, programs, policies, and projects necessary to realize the vision.
The study further recommends that developing countries should focus on economic diversification, promotion of circular economy, strengthening of multilateral trading system, infrastructure development, social protection, and international frameworks to build resilience to shocks. To achieve these goals, developing countries should undertake measures to make financial markets more stable, identify and analyze the actual or potential impacts of sustainability transitions, focus on environmental, trade, and social policies, invest in infrastructure, strengthen social protection systems, and establish a cooperative global financial and monetary system that ensures the same rules of the game are applied to all parties concerned.