Lecture Note 10

Balance of Payments, Debt, Financial

Crises, and Stabilization Policies
International Finance and Investment:
Key Issues

• How major debt crises emerged during the

1980s and 1990s?
The Balance of Payments Account

• General considerations:
– Balance of Payments (BOP)
• Current Account
• Capital Account

– Surplus and Deficit

A Schematic Balance of Payments Account
The Balance of Payments Account
• General considerations (cont’d)
– Cash Account or International Reserve Account
– Three forms:
• Hard currency
• Gold
• Deposits with IMF
Credits and Debits in the Balance of Payments
Account
The Balance of Payments Account

• A hypothetical illustration: deficits and

debts
– Current Account
– Capital Account
Table 13.3 A Hypothetical Balance of
Payments Table for a Developing Nation
The Balance of Payments Account

• A hypothetical illustration: deficits and

debts (cont’d)
– Inflow
– Outflow
– Amortization
Financing and Reducing Payments
Deficits

• Some initial policy issues

– The balance on current account plus the balance
on capital account must be offset by the balance
on cash account.

– If the country is very poor, it is likely to have

very limited stock of international reserves.
Financing and Reducing Payments
Deficits
• Some initial policy issues
– Overall balance of payments deficit can place
severe strains on poor developing countries

• Inhibit the countries’ ability to continue importing

needed capital and consumer goods.

– Policy options?
Financing and Reducing Payments
Deficits
• Policy options
– Promoting of exports & limiting imports
– Devaluation
• Lowering export prices and increasing import prices

– Loans from international organizations such as

IMF and World Bank
Ø Structural adjustment
Ø Free-market oriented reform
Ø Stabilization Policies(restrictive monetary and fiscal
policies)
Ø Reduction of inflation, cutting budget deficits, and
improving the balance of payments
Financing and Reducing Payments
Deficits
• Policy options
– Private foreign direct or portfolio investment
– Borrowing from international commercial banks
– Public foreign assistance

– Expanding stock of official monetary reserves

• Gold, hard currencies
• Acquisition of special drawing rights(SDRs)*
– * an international financial asset created by the IMF
Financing and Reducing Payments
Deficits
• Trends in LDC Balance of Payments
– Prior to 1980, the conventional development
strategy had LDCs operating with sizable current
account deficits,
• Imports of capital and intermediate goods were required
to provide the machinery and equipment for rapid
industrialization.

– Export earnings paid for most of these imports.

• Trends in LDC Balance of Payments
– The financing of these deficit was made possible by large
resource transfers in the capital account in the form of
• foreign aid,
• direct private investments by multinational
corporations,
• private loans by international banks to both LDC
governments and local business.

• Capital account surpluses, typically more than

compensated for current accounts deficits so that
international reserves were being accumulated.
• Trends in LDC Balance of Payments

– During the 1980s, the developing world

experienced a substantial deterioration in both
current and capital account balances.

– The brief period of current account surpluses,

which reflects entirely OPEC’s booming export
revenues of 1979-1980, abruptly turned negative
in 1981, stayed negative until 2000.
Table 13.4 Before and After the 1980s Debt Crisis: Current
Account Balances and Capital Account Net financial Transfers of
Developing Countries, 1978-1990 (billions of dollars)
Table 13.5 Developing Country Payments Balances
on Current Account, 1980–2009 (billions of dollars)
• Trends in LDC Balance of Payments
– Recent positive balances (outside Africa) have
been possible largely because of the widening
and unsustainably large U.S. trade deficit.

– The reasons for the decline in a current account

balances in the 1980s and 1990s included..??
• A dramatic fall in commodity prices
• Global recession in 1981-1982, and 1991-1993
• Increasing protectionism in the developed world against LDC
exports
• Severely overvalued exchange rates
• The capital account showed a dramatic turn
in the 1980s
– A combined result of rising LDC debt service
obligations,
– sharp declines in lending by international banks
– and massive capital flight.
The Debt Crisis of the 1980s
• Prior to the early 1970s, the external debt of
developing countries was relatively small and
primarily an official phenomenon.

• The majority of creditors was foreign governments

and international financial institutions such as the
IMF, the World Bank, and regional development
banks.
– More loans were on concessional terms.
• During the 1970s and early 1980s,
– Recycling of surplus OPEC petrodollars
• Commercial banks began playing a role in international
lending by recycling surplus OPEC “petrodollars”

• issuing general purpose loans to LDCs to provide

balance of payment support and expansion of export
sectors.
 The Debt Crisis of the 1980s

• Debt service: the payment of amortization

and accumulated interest

• Basic transfer: the net foreign-exchange

inflow or outflow related to its international
borrowing
Accumulation of Debt and Emergence of
the Debt Crisis

Net capital inflow, FN, is

FN = dD (13.1)

Basic transfer, BT, is

BT = dD - rD = (d - r ) D (13.2)

Where d is percent increase in total debt

D is total debt
r is the average interest rate
 The Debt Crisis of the 1980s
• If d>r, the country will gain foreign reserves and
vice versa.

– When LDCs have a relatively small total debt, D, the rate of

increase, d, is likely to be high.

– Concessional Loans:

• Most first stage debt accumulation comes from official sources

in the form of bilateral foreign aid and World bank lending,
• Most of the debt is incurred on concessional terms- at below
market interest rates with lengthy repayment periods.
 The Debt Crisis of the 1980s
• A serious problem can arise when

– The accumulated debt becomes very large so that its rate

of increase, d, naturally begins to decline as amortization
rises relative to rate of new gross inflows

– Change in loan structure:

• The sources of foreign capital switch from long-term official

flows on fixed, concessional terms to short-term, variable rate
private bank loans at market rates that cause r to rise
 The Debt Crisis of the 1980s
• A serious problem can arise when
– Problems in trade
• The country begins to experience severe balance of
payments problems as commodity prices decrease and
the terms of trade rapidly deteriorate

• A global recession or some other external shocks, such

as a jump in oil prices
 The Debt Crisis of the 1980s
• A serious problem can arise when
– Credibility issues
• A loss in confidence in an LDC’s ability to repay, causing
private international banks to cut off their flow of new
lending.

– Capital flights
• A substantial flight of capital is precipitated by local
residents who for political or economic reasons send
great sum of money out of the country
• invested in developed country financial securities, real
estate, and etc.
 The Debt Crisis of the 1980s

• All six factors can combine to lower d and raise r in

the basic transfer equation,
– Overall basic transfer becomes highly negative, and capital
flows from the underdeveloped countries to the developed
world.

• Heavily indebted developing countries are forced

into a downward spiral of negative basic transfers
– Dwindling foreign reserves, and stalled development
prospects.
Accumulation of Debt and Emergence of
the Debt Crisis

• Origins of the 1980s Debt Crisis

– OPEC oil price increase
– Increased borrowing
– Excess of imports
– Lagging exports
Origin of the Debt Crisis
• The seeds of the 1980s debt crisis were sown in the
1974-1979 period,

– There was a virtual explosion in international lending,

precipitated by the first major OPEC oil price increase.
Figure 13.1 The Mechanics of Petrodollar
Recycling
• The total external debt of developing countries
more than doubled from $180 billion in 1975 to
$406 billion in 1979. (increasing over 20%
annually)
– Non-concessional terms with shorter maturities and market
rates of interest.

• The large increase in the size of debt and the larger

proportion scheduled on harder terms were
responsible for the tripling of debt service
payments,

– from $25 billion in 1975 to $75 billion in 1979.

• In sum, the surge in international lending following
the first oil shock : 1974-1979.

• In a congenial economic atmosphere, developing

countries maintained relatively high rates of growth
with little debt servicing difficulty

• Recycling of oil dollars

– Provision of loans through private international banks
– It helped dampen the recession in industrialized countries
by providing for increased export demand on the part of
developing countries.
Origins of the 1980s Debt Crisis

• But, after the second oil shock in 1979,

– OPEC oil price increase
• Now developing countries faced an abrupt increase in
oil prices that added to oil import bills and affected
industrial goods imports.

– Lagging exports
• Decrease in LDC exports earnings
– a combination of slow growth in the more developed
nations
– and precipitous declines of over 20% in primary
commodity export prices.
Origins of the 1980s Debt Crisis
– Increased borrowing
• Moreover, developing countries inherited from the
previous period a huge debt and debt service obligation,

• More onerous by burgeoning interest rates and more

precarious as a result of bunching of short-term
maturities.
Origins of the 1980s Debt Crisis

• Capital flights
– During the entire period of debt accumulation, one
of the most significant and persistent trends was
the tremendous increase in private capital flight.

– Between 1976 and 1985, about $200 billion fled

the heavily indebted countries.
• equivalent of 50% of the total borrowings by LDCs over
the same period

• 60% of Argentina’s and 71% of Mexico’s debt growth are

estimated to have resulted from capital flight.
Accumulation of Debt and Emergence of
the Debt Crisis (cont’d)

• Origins of the Debt Crisis :Developing

countries’ two options:

• Curtail imports and restrictive fiscal and monetary

measures

• More external borrowing

Accumulation of Debt and Emergence of
the Debt Crisis

• Many countries were forced to rely on the option,

borrowing even more heavily
– Debt service obligations accumulated

• Nigeria, Argentina, Ecuador, and Peru were

experiencing negative economic growth in the
1980s

– and faced severe difficulties in paying even the interests

on their debts out of export earnings.
Accumulation of Debt and Emergence of
the Debt Crisis

• They could no longer borrow funds in the world’s

private capital markets.

• By 1984, the developing countries were paying

back $10.2 billion more to the commercial bank
than they were receiving in new loans.

• In the 1990s, the economic situations of

developing countries varied greatly:
– many experienced positive net transfers, but others
remain in crisis.
Attempts at Alleviation: Macroeconomic
Instability, IMF Stabilization Policies,
and Their Critics
• Renegotiation of loans
– One course of action that was used by countries facing with
the growing foreign-debt obligations was to renegotiate
loans with private international banks.

• to defer the payment period for principal and interest

• to obtain additional financing on more favorable terms.

– Need to negotiate with the IMF first before a consortium of

international banks would agree to refinance or defer
existing loan schedules.
Attempts at Alleviation: Macroeconomic
Instability, IMF Stabilization Policies,
and Their Critics

• The IMF stabilization program

– Four basic components of IMF stabilization
program:
• Liberalization of foreign exchange and imports control
• Devaluation of the official exchange rate
• Stringent domestic anti-inflation program
• Opening up of the economy to international commerce
• In the early 1980s, Mexico, Brazil, Argentina,
Venezuela, Bangladesh, Ghana had to turn to IMF to
secure additional foreign exchange.

• By 1992, ten countries had arranged to borrow a

total of $37.2 billion from the IMF.

• During the Asian financial crisis,

– Thailand ($3.9 billion)
– Pakistan ($1.6 billion)
– The Philippines ($435 million)
– Indonesia ($10 billion)
– South Korea ($21 billion)
• To receive their loans and to negotiate additional
credit from private bank,
☞ all these nations were required to adopt some or all of the
stabilization policies.

– Although such policies may be successful in reducing

inflation and improving the LDC’s balance of payment
situations,

• they can be politically unpopular.

 Criticism on the IMF recipe
• The IMF encourages LDCs to incur additional debt
from international financial institutions

– It blackmails them into anti developmental stabilization

programs.

– This added debt burden thus becomes a source of future

balance of payments problems.
Criticism on the IMF recipe

• Between 1982 and 1988, IMF strategy was tested in

28 of the 32 nations of Latin America and the
Caribbean.

– During the period, Latin America financed $145

billion in debt payments,
• at a cost of economic stagnation, rising unemployment,
and a decline in per capita income of 7%.

• The IMF’s policies of severe financial austerity for debtor

countries tend to inflict a harsh and often unnecessary
economic burden
Resolution and continued
vulnerabilities
• After the most significant international financial
crisis of the 1980s, at least until 1997, LDC debt
seemed all but disappeared.

• Restructuring of debts

– Almost 80% of the outstanding debt owed to commercial

banks by the most heavily indebted LDCs,

– a proportion owed to government and multinational

institutions
• Commercial bankers signed a debt-restructuring accord with
Argentina and Brazil in 1992.
Resolution and continued
vulnerabilities
• But, for many countries, especially in Africa, the
problem remained extremely serious.

– The situations is particularly acute in Sub-Saharan Africa,

– The region’s total debt is in many cases larger than

annual export earnings.

– Debt service payments have continued to exceed Africa’s

annual expenditure on health and education combined.
Debt service payment
• Economic growth for many low-income developing
countries turned negative, per capita income
steadily declined.
– A large burden of repayments
– A heavy dose of IMF restrictive policies
Recurrence of Debt Crises.

• Mexico, 1994
– Devalue its currency and seek standby loans to
pay off its short-term debt obligations.

– Almost half of the private portfolio investment

capital was withdrawn.

– Declare new austerity program, further

weakening the already deteriorating condition of
its middle class and its working poor.
• The 1997-1998 financial crisis.
– Asian countries such as Korea, Indonesia, and
Thailand, along with Russia, Brazil, and other
countries, borrowed from the IMF with strong
austerity condition.

– Austerity had led to unnecessarily large

recessions.

– Governments through East Asia worked to

accelerate exports, repay IMF loans, and greatly
expand foreign-currency reserves over the
subsequent decade.
The Global Financial Crisis and the
Developing Countries
• Causes of the crisis and challenges to lasting
recovery
– Financial deregulation in the U.S
• Repeal of rules separating commercial and investment
banking
• Failure to regulate newly introduced financial
instruments
• Artificially low interest rates
• Public policy to encourage home-ownership through
subprime lending
• The packaging and resale of loans with
understatements of their riskiness
• Failure of risk-rating agencies to fulfill their roles
The Global Financial Crisis and the
Developing Countries
• Causes of the crisis and challenges to lasting
recovery
– Fragile financial system in other developed
nations
• Some European countries such as Spain
• High leverage and complex and incompletely
understood financial securities
– Chronic international imbalances between East Asia and
the developed countries
• Capital flows into the U.S
• Cheap capital and housing bubbles in the U.S and some European
countries
The Global Financial Crisis and the
Developing Countries
• Sovereign debt problems in the developed nations
– EU-5 countries(Greece, Ireland, Italy, Portugal and Spain)
– International bailouts in 2010

Ø Fiscal stimulus
– Government spending to prop up weak demand and
prevent the onset of a depression
– Politically unsustainable
– Austerity measures in several developed and the deficit
countries of Europe

– IMF called on countries not to cut back on spending

• Historical irony
The Global Financial Crisis and the
Developing Countries
• Most international financial crises since World War
II were viewed as originating in the developing
world
– Weak financial markets and institutions and unstable
political economy
• Latin American debt crises of 1982
• The Mexican Tequila Crisis of 1994
• East Asian contagion of 1998
• Argentine default in 2001

– The affected countries were pressured to open

and liberalize their economies
• Latin American and African countries were required to
privatize state-owned enterprises
• Eliminate regulation, and reduce infant industry
protection
The Global Financial Crisis and the
Developing Countries
• East Asian countries were to required to open their
economies to more foreign direct investment

• The most recent crisis originated in the U.S.

– Accompanied by its worst economic downturn

– Developing countries helped to pull many countries out of

recession through their economic dynamism

– The stimulus packages in both developed and developing

countries kept the situation from getting worse
Appendix

Subprime Mortgage
Crisis
What is subprime mortgage?

• A type of loan granted to individuals with poor credit history

☞Deficient credit rating would not qualify them for a conventional

mortgage

☞ Such borrowers present high risk for lenders

☞Subprime mortgage lending charges interest rate above the prime

mortgage rate
 Sovereign Debt Crisis
• This is also known as Eurozone sovereign debt crisis.

• The term indicates financial woes caused due to overspending by

European countries

• When a nation live beyond its means by borrowing heavily and

spending freely, it comes a point when it cannot manage its
financial situations.

• When that country faces insolvency, lenders start to demand

higher interest rates, and the cornered nation is swallowed up
what is known as the Sovereign Debt Crisis.
Eurozone Crisis
• It is a combined sovereign debt crisis, a banking crisis, a growth and
competitiveness crisis.

• The Eurozone crisis is a economic crisis due to:

− collapse of financial institutions
− high government debt

• The crisis started in 2008 with the collapse of Iceland’s banking systems

• Three countries, Portugal, Iceland and Greece were significantly affected

• Led to the crisis of European businesses and economies