3

# **2  Channels of Transmission: From Financial Crisis to Social Crisis**

Financial crises are costly for development, and can have serious implications both for economic and social well-being of the people and countries. While everyone is vulnerable to their adverse consequences, financial crises hurt disproportionately the poor, as with natural disasters, contagious diseases, or climate change, given that the poor have limited capacity and instruments to insulate themselves from the shock and recover from the impact of the crisis. Failure to manage financial risks effectively, before and after the risk materializes, can undermine the resilience of the poor to withstand adverse consequences of future shocks, as well as their ability to take advantage of development opportunities. In any given country, crises hit particularly the most vulnerable—the young, the old, women, and the ill. A severe financial crisis can morph into a social crisis if it is poorly handled, working its way through a number of channels (diagram 1).<sup>4</sup>

**Product and labor market channel:** Financial crises weaken economic activity, dampen consumption and investment demand, and result in sustained declines in economic growth, loss of jobs, reduced wages and benefits, and higher unemployment (or vulnerable employment that typically involves fewer hours and lower benefits). Relative price adjustments and currency depreciation can exacerbate these effects, especially where the public and private sectors hold high levels of foreign currency-denominated debt. Past experiences with financial crises indicate that on average, unemployment increases by 1.4 percent during crises and it takes 4-5 years for employment to return to its pre-crisis levels after economic recovery starts.<sup>5</sup> For example, in Mexico and Argentina, unemployment and wages took a serious hit in the aftermath of the financial crises in 1994-95 and 2001-02, respectively.<sup>6</sup> In Cote d’Ivoire, formal employment fell by almost 40 percent during the crisis of the early 1980s.

**Financial market channel:** Financial crises are typically followed by reduced financial flows across countries (in the form of foreign capital and remittances), erosion of savings, and reduced availability and/or higher cost of credit. As ailing financial institutions retrench from foreign markets and earnings of migrant workers decline, reduced financial flows affect countries that rely heavily on foreign capital to support credit and economic activity. Savings are eroded by low interest rates reduced by policy makers to stimulate demand and protect bank balance sheets, by falling asset prices, or by crisis response measures such as freezing bank deposits or forcing conversion at unfavorable rates (Argentina in 2001 and Ecuador in 1998). Bank deleveraging to repair balance sheets and to adjust to scarce funding and increased economic uncertainty can create credit crunch, contributing to weak economic activity and unemployment. Households and small firms can be deprived of credit as banks tighten credit standards and lend only to large customers perceived as creditworthy. During the Asian crisis and the current global crisis, credit crunch was felt more among small and medium enterprises (SMEs).<sup>7</sup> In Chile, large firms with reduced access to external financing crowded out SMEs, which, faced with inflexible wages and high firing costs, filed for bankruptcy or switched to retained earnings for funds. The unemployment rate almost doubled and took some time to return to pre-crisis levels.<sup>8</sup>

> 4 See the companion background paper Calvo 2013 for a more detailed discussion. 5 Feyen 2009. 6 Pastor and Wise 2003. 7 Ding, Domec, and Ferri 1998 and Feyen, Kibuuka, and Ötker-Robe 2012.

> 8 Calvo 2013; World Bank 2005.