Monday, 23 February 2009

'Toxic' Assets, Contagion and the Financial Crisis

By Xavier Cirera

An interesting question regarding the spread of the current financial crisis is the extent to which banks in developing countries hold 'toxic' assets. This is critical to understanding the channels through which the crisis will spread to developing countries. It is already evident that there is a significant impact on developing countries from a reduction in demand in OECD countries (the trade channel). Recent news about a substantial decrease in exports from China is alarming. However, less clear is the impact through bank lending.

The bank lending channel depends on the bank asset position, which in turn may depend on whether the bank is foreign owned and the use of bank finance by domestic firms. Financial development in developing countries varies greatly between emerging markets and LDCs. One may think that the banking system in Latin America and Asia is clearly more exposed to the global banking crisis than financially underdeveloped banks in Sub-Saharan Africa. In addition, firms’ access to bank finance is very restricted in Sub-Saharan Africa and other LDCs. As a result, it may seem that LDCs are quite isolated from the financial channel of contagion since banks have a less vulnerable position and play a less important role in firms’ finance. Interestingly, so far there are no news reports about large bank collapses and rescues in LDCs.

However, greater isolation from the financial channel does not imply that the impact of the current crisis on GDP growth in LDCs will not be large. Some LDCs are already experiencing the drop in demand from OECD countries.

If you are interested in the issue of 'toxic' assets, do not miss the excellent note from my colleague Neil McCulloch on what to do about them.

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