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

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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, Czech Republic
 High income: US, France, Japan, Singapore, Kuwait

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1. Rich and Poor Countries
Country classification

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1. Rich and Poor Countries
Economic growth and catch-up I
 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

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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
• Why have some poor countries remained in poverty?
• 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 (see 4),
underground economies and corruption flourish.

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1. Rich and Poor
Countries
Characteristics of
Poor Countries V

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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 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),
decreasing investment and increasing interest rates,
leading to low aggregate demand, output and income.
 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.

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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 (further).

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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.
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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.

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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.
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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 the value of the ringgit.

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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.

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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
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?

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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
4. Increased equity finance relative to debt finance

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