Impact of the financial crisis on decentralisation
processes
Literature Review
Karem Roitman
Social Development Direct
29
June
2009
GSDRC Research Service
This literature review was commissioned by the European Commission (EC) through the
Governance and Social Development Resource Centre (GSDRC). The service addresses
emerging priority agendas of concern to the international development community.
For more information see www.gsdrc.org
Acronyms
AFC
GFC
IMF
KDP
LDC
LIC
LGU
NALAS
ODA
OFW
PDF
WB
WHO
Asian Financial Crisis
Global Financial Crisis
International Monetary Fund
Indonesian Kecamatan Development Programme
Less Developed Countries
Low Income Countries
Local Government Units
Network of Associations of Local Authorities of South-East Europe
Overseas Development Assistance
Overseas Filipino Workers
Philippine Development Forum
World Bank
World Health Organization
Table
of
Contents
1. Purpose of the review ......................................................................................................................... 1
2. Introduction ........................................................................................................................................ 1
3. The Global Financial Crisis................................................................................................................. 1
4. Links between financial crises and decentralisation .......................................................................... 3
5. Lessons learned and recommendations ............................................................................................... 5
6. Conclusion........................................................................................................................................... 6
7. Bibliography ........................................................................................................................................ 6
1. Purpose of the review
Based on agreed upon TOR and further conversations with the client, this Review provides
an overview of the impact of financial crises on decentralisation processes. Through a broad
literature review, this Review contributes to the identification of possible entry points to
mitigate the effects of the current global financial crisis (GFC) while ensuring macro
economic stability and proper functioning of public services. This review highlights lessons
from previous crises, risks and trends in the management of the crises by central and local
governments, practices that could mitigate the probability of further crises, and entry points
for external support.
2. Introduction
There is currently no empirical research on how global financial crises affect decentralisation
processes. At present we are still struggling to grasp fully how the GFC will affect developing
countries. Donors need to consider the short and long-term effects of the crisis to ensure aid
effectiveness in line with the latest Paris Declaration. This review seeks to engage
development practitioners working on decentralisation in a discussion of the effects of the
crisis by reviewing existing literature on the GFC, its implications, and possible ways
forward. This review will be structured as follows. First a brief overview of the GFC will be
provided, then the links between financial crises and decentralisation processes will be
discussed. Finally, lessons learned from previous crises and recommendations for the
present situation from existing literature will be highlighted.
3. The Global Financial Crisis
Data on the causes and effects of the GFC are still being gathered, and thorough research
in this area is still lacking. According to the ILO, a combination of inappropriate financial
regulations, excessive risk-taking by certain financial intermediaries, and inefficient
remuneration practices in the financial sector, has resulted in the current crisis (ILO 2009:
10). The crisis was first broadly noted when the US sub-prime mortgage market collapsed in
early 2007. The crisis then quickly spread through the financial system, compromising the
creditworthiness of major financial institutions, eroding the value of capital, and leading to
significant de-leveraging (WB 2009:2). Insecurity about assets’ values prompted capital
hoarding, drying up liquidity and, consequently, decreasing demand and employment (WB
2009: 2). According to the World Health Organization, the world now faces the most serious
economic downturn since the Great Depression of the 1930s (WHO 2009:3). The GFC will
affect countries differently depending on their economic structure, and the effects of the
crisis are the subject of much debate at the moment. The estimates presented in this review,
therefore, represent only the views of the sources cited.
Effects of the GFC on developing countries
The current GFC is affecting LDCs through financial links, trade links, and remittances, and
it might also affect ODA in the coming years. Large emerging economies have been strongly
affected by the present GFC (ILO 2009:11). Countries reliant on external borrowing for their
credit, including several in Eastern Europe and Central Asia, are being strongly affected
(WB 2009). Most LICs, as their banks are financed domestically or regionally, are shielded
from direct changes in private capital market flows (WB 2009). Willem te Velde et al have
found that credit conditions are tightening for bank lending in Cambodia, Ghana, and Zambia
(2009:vii). FDI has been affected less but is markedly lower than the record increase to
Africa in 2007 and 2008 (ibid). FDI is falling especially in the natural resource sectors (WB
2009: 3). “Bond issuances have been put on hold in Ghana, Kenya, and Uganda” (Willem te
Velde et al 2009:vii). It has been estimated that the GFC will increase the financing needs of
LICs by at least 25 billion USD in 2009 (IMF 2009:1). LDCs will have lower capital flows
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than in the last 8 years, which may entail weaker investments and therefore slower growth in
the years to come (WB 2009:1). Net financial flows may fall by as much as 25%; the WB
predicts a drop of $400-500 billion in until 2010 (Willem te Velde 2008:2).
Trade is estimated to contract 2.8% in 2009 (ILO 2009:11). Looking at specific countries, we
can note that manufacturing has been hit strongly, with Indonesian electronic exports
(accounting for 15% of all exports) falling 25% (in value terms) in January 2009 year-onyear, while the value of garment exports in Cambodia has fallen from a monthly average of
$250 million in 2008 to $100 million in January 2009 (Willem te Velde et al 2009:vii). The
prices of commodities (such as copper and oil) have also fallen drastically (40% for the price
of copper since July 2009), affecting countries like Nigeria, Zambia, and Bolivia (ibid). This
decrease in commodity prices, on the other hand, has partly offset the decrease in demand
in East Asia (WB 2009). Tourism has also decreased, with bookings falling by 40% in
‘Cambodia in 2008 (Willem te Velde 2008:2-3).
As remittances have become an important source of funding for many governments, their
decline due to the GFC is a cause for concern. The ODI estimates that remittances will fall
between $25 and $67 billion in 2009 (Cali 2009). In the first 8 months of 2008 remittances to
Mexico decreased by 4.2% and remittances to Kenya dropped by 27% y-to-y in January of
this year (Willem et al 2009:vii). Emigration from Bangladesh, a source of future remittances,
has fallen 38.8% year-on-year Feb. 2009 (Willem te Velde et al 2009:vii). Latin American
remittances are strongly connected to the well-being of the United States, economic woes in
the USA are transmitted to the South though falling remittances. The decline in remittances
is compounded for some countries by unfavourable exchange rates (WB 2009:8).
There is also a concern that donors might decrease their aid budgets in response to fiscal
pressure at home (WB 2009:1). However, up to date there is little evidence that aid will
decrease. It is too soon to ascribe observed aid declines, such as what has been noted for
Uganda in 2008, to the GFC (Willem te Velde et al 2009: vii). China has re-instated its
commitment to its aid agenda to Africa in the recent months (Cook and Lam 2009). The
need for aid to remain constant and even to be frontloaded to decrease the human costs of
the GFC has been repeatedly highlighted by donors (UNESCO 2009a, 2009b) while the WB
has estimated that, depending on the severity of the crisis and the strength and timing of
policies implemented, developing countries are likely to face a financing gap of $270-$700
billion (WB 2009:1)
The GFC will increase the number of individuals living in poverty throughout the world, as
has happened with previous crises (see Figure 1). In the current crisis the World Bank
expects the number of people living in poverty to increase to 49 million during this year (WB
2009:10). The effect of crises on poverty is long-term, as countries’ growth is affected by, for
example, a decrease in infrastructure spending (WB 2009:7). Infrastructure investment in
Asia and Latin America decreased substantially after the late 1990s crises and had still not
recovered fully by 2007 (WB 2009: 7). Over the last two years Cambodian growth has
declined from over 10% in 2007 to close to zero in 2009; Kenya’s growth decreased from
7% in 2007 to 3-4% in 2009 (Willem te Velde et al 2009:vii-viii).
2
Source IDS 2009b
4. Links between financial crises and decentralisation
Effects on central and local governments
Financial crises can affect both central and local governments. Crises can affect central
government revenue through 1) lower corporate taxes because of a decrease in private
economic activity, as well as through lower income tax and VAT revenues; 2) lower royalties
and mining taxes given by decreases in commodity export volumes and values; 3) lower
import taxes; 4) lower capital income; 5) decrease in ODA (Willem te Velde et al 2009: 27).
The effects on government budgets will be apparent differently in various contexts, from
lower tax receipts (e.g. Uganda, Q3 2009), to the end of expected increases in commodity
receipts (e.g. mining in Zambia), to lower government fuel import bills (e.g. Bangladesh,
where import duties make up 42% of total revenue collection in the country) (Willem te Velde
et al 2009: viii-ix).
The medium-term effect of the GFC on social protection is likely to be first felt in the 2009/10
budgets as the 2008/09 budgets underestimated the GFC’s impact on national revenue
(Willem te Velde et al 2009:30). As the full impact of the GFC is felt, fiscal pressure will be
felt at both the national and local level. Tension between central and local authorities might
be expected especially if the remit of social protection programmes fall under local
authorities.
Central governments may be torn between funding social protection and commitments to
reducing national deficits. In this situation, central government may opt to cut down in social
sector service delivery and in local budgets for the benefit of the national budget. In
Nigeria, for example, the 2009 federal budget cut education allocations by 16% and health
allocations by 29% (Willem te Velde et al 1009:30). The risk of intergovernmental fiscal
transfers from fiscal budget cuts is likely to be high during the GFC, and central
governments might use the GFC as an excuse to cut grants.
Previous crises have shown that in the face of government fiscal pressure and decreases in
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household income, demand on public services increases and, if these are not given financial
support, quality of care will deteriorate (WHO 2009: 5). In the health sector, previous crises
have shown that curative care has greater political buy in than preventative care, thus
preventative care is more likely to be cut, undermining long-term health development
objectives (WHO 2009:5). This was observed in Indonesia after the Asian Financial Crisis
(AFC) (Pineda 1999:23).
The crisis can be transmitted to local governments through higher unemployment and
social needs, and through difficulties in investment financing (Bernd 2008). Shrinking
economies can result in increasing unemployment that, in turn, prompts urban to rural
migration, as has been noted in China, and in the case of Cambodia construction workers in
2008 (Willem te Velde et al 2009:viii). De-urbanization increases pressure on the provision
of local services in rural sectors. Urban to rural migration, moreover, implies a movement of
workers to lower productivity areas, which will have long term effects for a country’s
economic development (WB 2009: 10).
A few countries (e.g. Kenya, Ghana, Bangladesh, Nigeria) have established crisis task
forces to research and respond to the current financial crisis. All others, however, need to
set up such forces to provide urgently needed research on the country-specific effects of the
GFC and advise on policy.
Can Decentralisation make crises worse?
Depending on how decentralisation is undertaken, it is possible that it might contribute to
financial crises. Rodriguez-Pose and Gil (2005) argue that, in the few instances where there
are not strict regulations for local government borrowing, a separation between fiscal
freedoms and responsibilities can cause agency problems leading to financial disarray. For
example, in Brazil during the 1990s larger states issued bonds resulting in deficits that had
serious macroeconomic consequences, and states had to be bailed out by the central
government in Mexico during the 1995 financial crisis (2005: 18). In Italy, devolving revenue
raising responsibilities to the region was used to deal with soft budget constraints that had
led to the financial crises of 1992 through subnational borrowing (Rodriguez-Pose and Gil
1005:19). Jin and Zou (2003) have noted that Chinese provinces regularly overspend,
through indirect and foreign borrowing as well as from largely unaccountable use of extrabudgetary funds which comprise almost 50% of total government revenue in 1996 (cited in
Rodriguez-Pose and Gill 2005: 19). The decentralisation process in Indonesia has been
seen as adding to the challenge of financial recovery after the Asian crisis as “…many laws
and regulations [were] incomplete or conflicting...local governments [were] given greater
authority to establish local taxes… creating a perceived and real burden on the private
sector” (Frej 2004, see also Lewis 2006).
As demonstrated by Italy’s case, agency problems can be dealt with by devolving revenueraising responsibilities to local governments, or by re-centralizing spending abilities. The
former option is more desirable to maintain decision making closer to users in a democratic
fashion, but it is more challenging in a shrinking economy, where local governments are
unlikely to be able to increase their revenue. Governments have several policy options in
the face of financial crises: they can maintain their set course, engage in a pro-active
agenda of accelerating growth (e.g. Cambodia), implement fiscal stimuli (e.g. Indonesia), or
use monetary policy (e.g. Kenya) (Willem te Velde et al 2009: viii-ix).
Can crises serve as opportunities for decentralisation?
Donors and researchers have highlighted that the GFC can serve as an opportunity for
reform and to set up social safety nets (WHO 2009:5). Mexico, for instance, institutionalized
its PROGRESA/Oportunidades programme after the Tequila crisis. In Indonesia the 1997
financial crisis was a contributing factor to an expansive and rapid decentralisation
processes (Frei 2004). If the opportunity is not used, some scholars argue that “…existing
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policy and institutional trajectories are likely to be reinforced or intensified rather than
redirected and restructured” by the GFC, noting how in Malaysia a “centralized and
fragmented” bureaucracy with limited ability to spend assigned budgets, has “limited private
sector participation” after the AFC (Ritchie 2005:275-6).
It must also be noted that community directed development has proven successful in the
past even in the midst of crises. Wong and Guggenheim, for example, find that even during
the AFC KDP disbursed funds nearly twice as fast, on average, as agriculture, health, and
education projects implemented through central government line departments (2005: 259).
5. Lessons learned and recommendations
Experiences with previous financial crises have left a variety of lessons to be heeded by
central and local governments, as well as by donors and IFIs. This section will highlight
lessons relevant to processes of decentralisation.
A long-term perspective
A crisis can serve as an excuse for governments to cut investments needed for long-term
growth, such as infrastructure. Crises can also led to de-urbanization increasing pressure on
the budgets of local governments to provide social safety nets for newly unemployed
populations. For both of these reasons it is important that countries’ on-going investment in
local governments and long-term development be supported through the crisis if long-term
falls in growth are to be minimized.
Research-based policymaking
Policy making should match the nature of the crisis (Revenga 2009), implying the need for
grounded research on the impacts of the crisis in a country’s central and local governments
(Willem te Velde 2008). It is further important to ensure that policy making is pro-poor to
avoid elite capture (WHO 2009). The GFC poses a risk of intergovernmental fiscal transfers
from budget cuts as governments use the crisis as an excuse for political cuts. Stakeholders
need to address this through evidence-based advocacy to ensure the maintenance of
government investments for long term growth,
Balancing a strong central government with the needs of local governments
Reviewing the experiences of Indonesia during the 1997 crisis, Aswicahyono et al (2008)
argue that crisis resolution requires a strong credible government and that decentralisation
measures introduced in the wake of crises can undermine this (2008:267). On the other
hand, relying too heavily on the central government might waste valuable knowledge
available at the local level. In the case of the Philippines, the central government has
historically taken the responsibility for addressing economic crises under the assumption
that shocks are most likely to affect urban areas. However, processes of de-urbanization, as
noted above, the greater global integration of local economies, and the local impact of
returning OFWs, has increase the pressure on rural areas, which local governments might
be better able to deal with (PDF 2009).
Improving communication between central and local governments
Improved communication between central and local governments can prevent the principalagent problem highlighted in the previous section (Rodriguez-Pose and Gill 2005).
Streamlined communication will: 1) allow both central and local governments to set priorities
more accurately; 2) permit early identification of local consequences from the GFC; 3)
support joint programming of countercyclical spending (NALAS 2009); 4) gain local support
for strategies to address the crisis.
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Maximising local governments’ strengths
The Philippine Working Group on Decentralisation and Local Government (PDF) has noted
that in the GFC local governments might be better positioned to 1) design and implement
counter-cyclical measures to stimulate the local economy; 2) promote local productivity to
ensure the country’s competitiveness in trade once the global crisis is overcome (PDF
2009).
Support local governments’ endeavours
In order to maximize local governments’ strengths, these need to be assisted in 1)
understanding the impact of the crisis through thorough research; 2) designing safety nets
for newly impoverished and displaced workers; 3) implementing programmes that are
consistent with the national agenda; 4) capacity building to undertake strategic expenditures
(PDF 2009). PDF argues that access to financing for Local Government Units (LGU) should
be expedited to permit their investment on long-term wealth generating projects like
infrastructure.
Cooperation between local governments
LGUs need to improve their competitiveness to attract investment (NALAS 2008). In seeking
competitiveness, LGUs should share best practices (NALAS 2008) to promote efficiency and
avoid wasteful rent-seeking behaviour between regions.
6. Conclusion
Decentralisation processes are inherently intricate and mined with challenges, as they must
consider conflicting local and central interests and navigate the complexity of simultaneous
administrative, political, and economic decentralisations. Financial crises add another layer
of complexity, altering the balance of the economy and creating fiscal pressure for both
central and local governments. The effects of a crisis on an economy will vary according to
the nature of the crisis and the economy’s structure; thus creating appropriate policies
requires detailed, grounded research. To date very little research exists on the specific
effects of financial crises on countries’ decentralisation processes. The development sector
is at present struggling to grasp what the GFC will mean for developing countries. Despite
this lack of information, however, general patterns from previous crises have taught us: 1)
the importance of supporting countries’ investment on long-term growth and, 2) the need to
seek a balance between central and local governments, a balanced based on solid
communication and mutual support, to maximize the strength of local governments and use
these strengths to support countries’ struggle out of crises.
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