Chapter 8
Developing Countries:
Growth, Crisis, and Reform
Content
Rich and poor countries
Borrowing and debt in developing economies
Latin American crises
East Asian crisis
Lessons from crises and potential reforms
22-2
1. Rich and Poor Countries
Country classification
Low income: most sub-Saharan Africa, South
Asian countries
Lower-middle income: Vietnam, Caribbean
countries
Upper-middle income: Brazil, Mexico, Saudi
Arabia, Malaysia, South Africa,
High income: US, France, Japan, Singapore,
Kuwait
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1. Rich and Poor Countries
Country classification
22-4
1. Rich and Poor Countries
Economic growth and catch-up
The convergence theory states that, given
free trade, free capital movement and
technological transfers, poor countries will
eventually converge with the rich countries
While some previously middle and low
income countries economies have grown
faster than high income countries, and
thus have “caught up” with high income
countries, others have languished
(deceptively simple).
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1. Rich and Poor Countries
Economic growth and catch-up II
22-6
1. Rich and Poor Countries
Income and economic growth
Poor countries have not grown faster:
growth rates relative to per capita GDP in 1960
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1. Rich and Poor Countries
Characteristics of Poor Countries I
• Government control of the economy
• Unsustainable macroeconomic polices which
cause high inflation and unstable output and
employment
• If governments can not pay for debts through
taxes, they can print money to finance debts.
• Seignoirage is paying for real goods and services by
printing money.
• Lack of financial markets that allow transfer
of funds from savers to borrowers
• Weak enforcement of economic laws and
regulations
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1. Rich and Poor Countries
Characteristics of Poor Countries II
5. Low level of human capital: Low measures of
literacy, numeracy, and other measures of
education and training
Human capital makes workers more productive.
6. A large underground economy relative to official
GDP and a large amount of corruption
Because of government control of the economy (see 1)
and weak enforcement of economic laws and
regulations, underground economies and corruption
flourish.
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1. Rich and Poor
Countries
Characteristics of
Poor Countries V
22-10
2. Borrowing and Debt in Developing Countries
Borrowing and debt
Many middle income and low income countries
have borrowed extensively from foreign
countries.
Financial capital flows from foreign countries are able to
finance investment projects, eventually leading to higher
production and consumption.
But some investment projects fail and other borrowed
funds are used primarily for consumption purposes.
Some countries have defaulted on their foreign debts
when the domestic economy stagnated or during
financial crises.
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2. Borrowing and Debt in Developing Countries
Investment, savings and current account II
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2. Borrowing and Debt in Developing Countries
Types of Financial Capital
• Bond finance: government or commercial bonds
are sold to private foreign citizens.
• Bank finance: government and firms borrow
from foreign banks.
• Official lending: the World Bank or other official
agencies lend to governments.
• Foreign direct investment: a foreign firm
directly acquires or expands operations in a
subsidiary firm.
• Portfolio equity investment: a foreign investor
purchases equity (stock) for his portfolio.
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2. Borrowing and Debt in Developing Countries
Types of Financial Capital
Debt finance includes bond finance, bank finance
and official lending.
Equity finance includes direct investment and
portfolio equity investment.
While debt finance requires fixed payments
regardless of the state of the economy, the value
of equity finance fluctuates depending on
aggregate demand and output.
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2. Borrowing and Debt in Developing Countries
The Problem of “Original Sin”
When developing economies borrow in international
capital markets, the debt is almost always
denominated in US$, yen, euros: “original sin”.
A depreciation/devaluation of domestic currencies
causes an increase in the value of liabilities (debt).
The debt of the US, Japan and European
countries is mostly denominated in their respective
currencies.
When a depreciation of domestic currencies occurs,
liabilities (debt) do not increase, but the value of
foreign assets increases.
A devaluation of the domestic currency causes an increase
in net foreign wealth.
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2. Borrowing and Debt in Developing Countries
Financial crisis
A financial crisis may involve
• A debt crisis: an inability to repay government
debt or private sector debt.
• A balance of payments crisis under a fixed
exchange rate system.
• A banking crisis: bankruptcy and other
problems for private sector banks.
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2. Borrowing and Debt in Developing Countries
Debt crisis
• A debt crisis (sovereign debts) in which
governments default on their debt can be a self-
fulfilling mechanism.
• Fear of default reduces financial capital inflows and
increases financial capital outflows (capital flight),
leading to low aggregate demand, output and income.
• This can be seen from savings-investment identity (CA
=S-I): financial capital outflows force an increase in the
current account balance, which requires an increase in
savings or decrease in investment.
• Low income and high interest rates make it even
harder to repay debts
The government may have no choice but to default
on its debts. 22-17
2. Borrowing and Debt in Developing Countries
Balance of payment and banking crises
A debt crisis, a balance of payments crisis and a
banking crisis can occur together, and each can
make the other worse.
International reserves may be depleted, forcing
the central banks to abandon the fixed
exchange rate
A currency devaluation and the high interest
rate increase the debt burden and bankruptcy.
Each can cause aggregate demand, output and
employment to fall.
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3. Latin American Financial Crises
Debt crisis in Latin America
During 1970s, many Latin American countries
heavily borrowed from industrial countries and
resulted in a rapid buildup of foreign debts
In 1980s, the world economic recession made it
hard for these countries to repay their debts
High interest rates and an appreciation of the US
dollar drastically increased the burden of dollar
denominated debts.
A worldwide recession and a fall in many
commodity prices also hurt export sectors in these
countries.
In August 1982, Mexico announced that it could
not repay its debts, mostly to private banks. 22-19
3. Latin American Financial Crises
Debt crisis
The US government insisted that the
private banks reschedule the debts, and
in 1989 Mexico was able to achieve:
a reduction in the interest rate,
an extension of the repayment period
a reduction in the principal by 12%
Brazil, Argentina and other countries
were also allowed to reschedule their
debts with private banks after they
defaulted.
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3. Latin American Financial Crises
Reforms in Latin American countries (I)
Latin America countries implemented
stabilization programs and structural reforms,
including
Reducing government deficits through
spending cuts and tax reforms.
Privatization
Trade liberalization.
22-21
3. Latin American Financial Crises
Reforms in Latin American countries (I)
In order to cope with hyper inflation, American
countries adopted fixed exchange rate system:
The crawling peg and crawling band in Mexico
The crawling peg in Brazil
The currency board in Argentina
The exchange rate based stabilization program
had successfully brought inflation under control.
But these policies led to the real appreciation of
domestic currency and reduced competitiveness.
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3. Latin American Financial Crises
Crisis in Mexico
The real appreciation of peso led to a large
current account deficit.
Foreign reserves fell sharply because of the
devaluation fears and the credits extended by the
government to cover loan losses.
The government devaluated the peso by 15% in
December 1994, and later allowed it to float.
There was a risk of default, but the disaster was
avoided thank to 50$ billion emergency loans fom
the US and IMF
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3. Latin American Financial Crises
Crisis in Brazil
Even inflation was brought down, the economic
growth remained slow, and the budget deficits
rose.
The market lose confidence on the ability of the
central bank to maintain the crawling peg.
The government did devalue the real in 1999 and
then allowed it to float
Widespread banking crisis was avoided because
Brazilian banks and firms did not borrow extensively in
dollar denominated assets.
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3. Latin American Financial Crises
Crisis in Argentina
Due to the relatively rapid peso price increases,
markets began to speculate about a peso
devaluation.
A global recession in 2001 further reduced the
demand for Argentinean goods and services.
Argentina tried to uphold the fixed exchange
rate, but the government devalued the peso in
2001 and shortly thereafter allowed its value to
fluctuate.
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3. Latin American Financial crisis
Reforms and crisis in Chile
Chile suffered a recession and financial crisis in
the 1980s, but thereafter
enacted stringent financial regulations for banks and
grant the central bank independance.
removed the guarantee from the central bank that
private banks would be bailed out if their loans failed.
imposed financial capital controls on short term debt, so
that funds could not be quickly withdrawn during a
financial panic.
Chile avoided a financial crisis in the 1990s.
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4. East Asian Financial Crises
High economic growth achieved during
1960-1990 have turned many East Asian
countries to middle- or high middle-
income countries
What explain for the East Asian Miracle?
East Asian countries adopted an outward-
oriented development strategies, invested in
education, maintained macroeconomic stability
and had high savings and investment,
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4. East Asian Financial Crises
East Asian weaknesses
Despite the rapid economic growth in East
Asia between 1960–1997, growth was
predicted to slow as economies “caught up”
with Western countries.
Most of the East Asian growth during this period is
attributed to an increase in physical capital and an
increase in education.
Returns to physical capital and education are
diminishing,
as more physical capital was built and as more people
acquired more education and training, each increase
became less productive.
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4. East Asian Financial Crises
East Asian weaknesses
Before1990s,Indonesia, Korea, Malaysia, Philippines, and
Thailand relied mostly on domestic saving to finance
investment.
But afterwards, foreign financial capital financed much
of investment.
. Weak of enforcement of financial regulations and a lack of
monitoring created moral hazard
• Ties between businesses and banks and government
regulators helped to foster moral hazard.
• Firms, banks and borrowers engaged in risky
activities.
• The excessive lending and investment driven by moral
hazards eventually caused the downward spiral of
falling prices and falling banks. 22-29
4. East Asian Financial Crises
East Asian weaknesses
Non-existent or weakly enforced
bankruptcy laws and loan contracts
caused problems after the crisis started.
Financially troubled firms stopped paying
their debts, and they could not operate
because no one would lend more until
previous debts were paid.
But creditors lacked the legal means to
confiscate assets or restructure firms to make
them productive again.
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4. East Asian Financial Crises
The currency crisis
The East Asian crisis started in Thailand in 1997,
but quickly spread to other countries.
A fall in real estate prices, and then stock prices weakened
aggregate demand and output in Thailand.
A fall in aggregate demand in Japan, a major export
market, also contributed to the economic slowdown.
Speculation about a devaluation in the value of the baht
occurred, and in July 1997 the government devalued the
baht slightly, but this only invited further speculation.
Malaysia, Indonesia, Korea, and the Philippines
soon faced speculations about the value of their
currencies.
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4. East Asian Financial Crises
East Asian crisis
Most debts of banks and firms were denominated
in US dollars, so that devaluations of domestic
currencies made the burden of the debts in
domestic currency increase.
To maintain fixed exchange rates would have
required high interest rates and a reduction in
government deficits, leading to a reduction in
aggregate demand, output and employment.
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4. East Asian Financial Crises
Short-term Debt Inflows
80
60
40
20
0
1990-95 1996 1997(I+II) 1997 (III) 1997(IV) 1998(I+II) 1998(III) 1998(IV)
-20
-40
-60
-80
-100
-120
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4. East Asian Financial Crises
Bad Debts (% of total debts)
Thailand
Taiwan
Singapore
Phillipines
1997
Korea 1996
Malaysia
Indonesia
Hong kong
0 5 10 15 20 25 30 35 40
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4. East Asian Financial Crises
Policy responses to the crisis
All of the effected economies except Malaysia
turned to the IMF for loans to address the
balance of payments crises and to maintain the
value of the domestic currencies.
The loans were conditional on increased interest rates
(reduced money supply growth), reduced budget
deficits, and reforms in banking regulation and
bankruptcy laws.
Malaysia instead imposed financial capital
controls so that it could increase its money
supply (and lower interest rates), increase
government purchases, and still try to maintain
22-35
the value of the ringgit.
4. East Asian Financial Crises
Consequences of the East Asian crisis
Crisis affected countries experienced a sharp
contraction in output, widespread bankruptcy
and a rise in unemployment, but the down fall
was short-lived.
Economic instability and political instability
reinforced each other
Due to decreased consumption and investment
that occurred with decreased output, income and
employment, imports fell and the current account
increased after 1997.
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5. Lessons from crises and potential reforms
Lessons of Crises
1. Choosing the right exchange rate: Fixing the
exchange rate may be costly.
High inflation or a drop in demand for domestic
exports leads to an over-valued currency and
pressure for devaluation.
Given pressure for devaluation, commitment to a
fixed exchange rate usually means high interest
rates and a reduction in domestic prices.
A fixed currency may encourage banks and firms to
borrow in foreign currencies, but a devaluation will
cause an increase in the burden of this debt and
may lead to a banking crisis and bankruptcy (Moral
hazard).
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5. Lessons from crises and potential reforms
Lessons of Crises
2. The importance of a sound banking sector:
Weak enforcement of financial regulations can
lead to risky investments and a banking crisis
when a currency crisis erupts.
3. The proper sequence of reforms: Liberalizing
financial capital flows without implementing
sound financial regulations can lead to financial
capital flight when risky loans or other risky
assets lose value during a recession.
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5. Lessons from crises and potential reforms
Lessons of Crises
4. The importance of contagion: even
healthy economies are vulnerable to
crises when expectations change.
Expectations about an economy often change
when other economies suffer from adverse
events.
International crises may result from
contagion: an adverse event in one country
leads to a similar event in other countries.
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5. Lessons from crises and potential reforms
Potential Reforms: Policy Trade-offs
Countries face trade-offs when trying to achieve
the following goals:
exchange rate stability
financial capital mobility
autonomous monetary policy devoted to domestic goals
Generally, countries can attain only 2 of the 3
goals, and as financial capital has become more
mobile, maintaining a fixed exchange with an
autonomous monetary policy has been difficult.
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5. Lessons from crises and potential reforms
Policy trilemma)
5. Lessons from crises and potential reforms
Potential reforms: Preventive measures
1. Better monitoring and more transparency: more
information for the public allows investors to
make sound financial decisions in good and bad
times
2. Stronger enforcement of financial regulations:
reduces moral hazard
3. Enhanced credit lines- (financial supports)
4. Increased equity finance relative to debt finance
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5. Lessons from crises and potential reforms
Potential reforms: policy responses to a crisis
1. Bankruptcy procedures for default on
sovereign debt and improved bankruptcy law
for private sector debt.
2. A bigger or smaller role for the IMF as a lender
of last resort?
22-43