Global Financial Stability and Its Effects on Developing Countries

Introduction: Global Financial Stability and the Developing World

The condition of global financial stability implies that the world's financial institutions are healthy, that macroeconomic risks are within normal bounds, and that the risk environment — including appetite for risk — is at normal levels (IMF, 2014). There are differences between the ways that the macroeconomic environment affects the developed and developing worlds, and this paper focuses on the latter. The economic structure and vulnerability levels of the developing world, as well as their often-reduced participation in the global economic system, create different reactions to the condition of global financial stability.

Global financial stability is fostered by the economic health and stability of the world's largest and most interconnected economies. The European Union, United States, Japan, and other developed nations contribute to the prevailing conditions in the global macroeconomic environment. These economies tend to be highly interconnected. For example, when issues emerged in U.S. credit markets in 2008, much of the Western world was dragged into recession alongside the U.S. — except those nations with strict capital controls in their banking systems, though even they experienced slowdown.

The developing world was affected in different ways. Some developing nations are highly connected to the major Western economies — for example, 78% of Mexican exports go to the United States — and therefore their economic performance is more closely correlated with global financial stability. Other nations have economic strengths of their own and trade networks that extend beyond dependence on the West. China saw a slight slump in 2009 but almost immediately began a recovery. Still other nations in the developing world were barely affected at all — many African nations were not significantly impacted because they are not deeply integrated into the global economic system.

Other nations have reference countries that are not part of the West or were less affected by the crisis. Many Pacific island nations are dependent on Australia or New Zealand, which were not as strongly affected by the slowdown. Other nations use Russia, China, or South Africa as their reference economies — countries that were already less vulnerable to global financial instability. Given all of these different characteristics, the outcomes for the developing world of any given level of global economic stability vary considerably.

Trade

Global financial stability fosters trade because of stable interest rates, healthy credit markets, and healthy aggregate demand. When the global financial system is unstable, interest rates may drop as a point of monetary policy in developed nations, but a flight to quality could raise rates in the developing world. Credit markets could dry up, and aggregate demand is likely to fall. As noted, how much the latter matters depends on the degree of dependence of the emerging market in question. But credit markets matter because they facilitate trade — if buyers cannot finance their purchases, the seller suffers.

Mexico, being highly dependent on the U.S., saw its GDP collapse in 2010 as a result of global financial instability (Trading Economics, 2014). Malawi, far removed from the global financial system, saw no such decline related to the Great Recession (Ibid). So for countries with close ties to the global economic system — many of which depend on North American and European trade — exports and trade are expected to fall during times of global financial instability and rise during times of stability. Countries far removed from the financial system are unlikely to see these effects.

Foreign Direct Investment

Whatever the net effect on their economy from the level of global financial instability, foreign direct investment (FDI) should generally fall during times of instability and rise during times of stability. Access to credit is a critical factor here, because credit in home markets tends to be a key driver — along with market opportunity — of FDI. Global financial stability allows companies to finance major deals, which can be a key driver of FDI figures. One example is the AB InBev purchase of Grupo Modelo, which drove record FDI in Mexico in 2013 (Reuters, 2014). The country had seen FDI slump badly in 2009 due to constricted credit markets in the U.S. (Lange, 2010). This effect should be less pronounced in countries less dependent on the global financial system.

Another important dimension of FDI is that some developing nations can actually gain investment during periods of global financial instability. This may seem counterintuitive, but during such times returns in Western markets can be very poor, forcing capital to seek out returns in the developing world. Mongolia saw FDI spike during the Great Recession as Australian and Canadian companies invested heavily in its mining sector in anticipation of a rapid recovery in Asia (Els, 2014). That country's FDI has since fallen during a more stable global environment, illustrating the countercyclical nature of FDI in some emerging markets. Similarly, capital inflows to Nigeria peaked in 2008–2009 at the depths of the crisis, with investors chasing returns in the developing world (Vanguard, 2011).