Developing Countries:

Growth, Crisis, and Reform

Characteristics of Poor Countries
• What causes poverty?
• A difficult question, but low income countries have at
least some of following characteristics, which could
contribute to poverty:
1. Government control of the economy
• Restrictions on trade
• Direct control of production in industries and a high level
of government purchases relative to GNP
• Direct control of financial transactions
• Reduced competition reduces innovation; lack of market prices
prevents efficient allocation of resources.
Characteristics of Poor Countries (cont.)

2. 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.
• Seignoirage generally leads to high inflation.
• High and variable inflation is costly to society; unstable output
and employment is also costly.
Characteristics of Poor Countries (cont.)

3. Lack of financial markets that allow transfer of funds from savers to borrowers
4. Weak enforcement of economic laws and regulations
• Weak enforcement of property rights makes investors less willing to engage in investment
activities and makes savers less willing to lend to investors/borrowers.
• Weak enforcement of bankruptcy laws and loan contracts makes savers less willing to lend
to borrowers/investors.
• Weak enforcement of tax laws makes collection of tax revenues more difficult, making
seignoirage necessary
Characteristics of Poor Countries (cont.)

• Weak of enforcement of banking and financial regulations (e.g., lack of examinations, asset
restrictions, capital requirements) causes banks and firms to engage in risky or even
fraudulent activities and makes savers less willing to lend to these institutions.
 A lack of monitoring causes a lack of transparency
(a lack of information).
 Moral hazard: a hazard that a borrower (e.g., bank or firm) will engage in activities that
are undesirable
(e.g., risky investment, fraudulent activities) from the less informed lender’s point of
view.
Characteristics of Poor Countries (cont.)

5. 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.
6. Low measures of literacy, numeracy, and other measures of education and
training: low levels of human capital
• Human capital makes workers more productive.
Characteristi
cs of Poor
Countries
(cont.)
Borrowing and Debt
in Developing Economies
• Another common characteristic for many middle income and low income
countries is that they 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.
Borrowing and Debt
in Developing Economies (cont.)
• national saving – investment = the current account
• where the current account is approximately equal to the value of exports minus the value of
imports

• Countries with national saving less than domestic investment will have a financial
capital inflows and negative current account (a trade deficit).
Borrowing and Debt
in Developing Economies (cont.)
A financial crisis may involve
1. a debt crisis: an inability to repay government debt or private sector debt.
2. a balance of payments crisis under a fixed exchange rate system.
3. a banking crisis: bankruptcy and other problems for private sector banks.
Latin American Financial Crises
• In the 1980s, high interest rates and an appreciation of the US dollar, caused the
burden of dollar denominated debts in Argentina, Mexico, Brazil and Chile to
increase drastically.
• 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.
Latin American Financial Crises (cont.)

• 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.
Latin American Financial Crises (cont.)

• The Mexican government implemented several reforms due to the

crisis. Starting in 1987,
• It reduced government deficits.
• It reduced production in the public sector
(including banking) by privatizing industries.
• It reduced barriers to trade.
• It maintained an adjustable fixed exchange rate (“crawling peg”) until 1994 to
help curb inflation.
Latin American Financial Crises (cont.)

• Political instability and the banks’ loan defaults contributed to

another crisis in 1994, after which the Mexican government allowed
the value of the peso to fluctuate.
Latin American Financial Crises (cont.)

• Staring in 1991, Argentina carried out

similar reforms:
• It reduced government deficits.
• It reduced production in the public sector by privatizing industries.
• It reduced barriers to trade.
• It enacted tax reforms to increase tax revenues.
• It enacted the Convertibility Law, which required that each peso be backed
with 1 US dollar, and it fixed the exchange rate to 1 peso per US dollar.
Latin American Financial Crises (cont.)

• Because the central was not allowed to print more pesos without have more
dollar reserves, inflation slowed dramatically.
• Yet inflation was about 5% per annum, faster than US inflation, so that the
price/value of Argentinean goods appreciated relative to US and other foreign
goods.
• 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 currency.

22-16
Latin American Financial Crises (cont.)

• Maintaining the fixed exchange rate was costly because high interest
rates were needed to attract investors, further reducing investment
and consumption demand, output and employment.
• As incomes fell, tax revenues fell and government spending rose,
contributing to further peso inflation.

22-17
Latin American Financial Crises (cont.)

• Argentina tried to uphold the fixed exchange rate, but the

government devalued the peso in 2001 and shortly thereafter allowed
its value to fluctuate.
• It also defaulted on its debt in December 2001 because of the
unwillingness of investors to re-invest when the debt was due.

22-18
Latin American Financial Crises (cont.)

• Brazil carried out similar reforms in the 1980s and 1990s:

• It reduced production in the public sector by privatizing industries.
• It reduced barriers to trade.
• It enacted tax reforms to increase tax revenues.
• It created fixed the exchange rate to 1 real per
US dollar.
• But government deficits remained high.

22-19
Latin American Financial Crises (cont.)

• High government deficits lead to inflation and speculation about a

devaluation of the real.
• The government did devalue the real in 1999, but a widespread
banking crisis was avoided because Brazilian banks and firms did not
borrow extensively in dollar denominated assets.

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Latin American Financial Crises (cont.)

• Chile suffered a recession and financial crisis in the 1980s, but thereafter
• enacted stringent financial regulations for banks.
• 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.
• granted the central bank independence from fiscal authorities, allowing slower money supply
growth.
• Chile avoided a financial crisis in the 1990s.

22-21
East Asian Financial Crises
• Before the 1990s, Indonesia, Korea, Malaysia, Philippines, and
Thailand relied mostly on domestic saving to finance investment.
• But afterwards, foreign financial capital financed much of investment,
and current account balances turned negative.

22-22
East Asian Financial Crises (cont.)

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East Asian Financial Crises (cont.)
• More directly related to the East Asian
crises are issues related to economic laws and regulations:
1. Weak of enforcement of financial regulations and a lack of
monitoring caused firms, banks and borrowers to engage in risky or
even fraudulent activities: moral hazard.
• Ties between businesses and banks on one hand and government
regulators on the other hand lead to some risky investments.

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East Asian Financial Crises (cont.)
2. 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.

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East Asian Financial Crises (cont.)
• 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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East Asian Financial Crises (cont.)
• Most debts of banks and firms were denominated in US dollars, so that
devaluations of domestic currencies would make the burden of the debts in
domestic currency increase.
• Bankruptcy and a banking crisis would have resulted.
• 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.
• This would have also lead to widespread default on debts and a banking crisis.

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East Asian Financial Crises (cont.)
• 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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Russia’s Financial Crisis
• After liberalization in 1991, Russia’s economic laws were weakly enforced or non-
existent.
• There was weak enforcement of banking regulations, tax laws, property rights, loan contracts
and bankruptcy laws.
• Financial markets were not well established.
• Corruption and crime became growing problems.
• Because of a lack of tax revenue, the government financed spending by seignoirage.
• Due to unsustainable seignoirage, interest rates rose on government debt to reflect high
inflation and the risk of default.

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Russia’s Financial Crisis (cont.)
• The IMF offered loans of foreign reserves to try to support the fixed exchange
rate conditional on reforms.
• But in 1998, Russia devalued the ruble and defaulted on its debt and froze
financial capital flows.
• Output fell in 1998 but recovered thereafter, partially helped by rising oil prices.
• Inflation rose in 1998 and 1999 but fell thereafter.

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Russia’s Financial Crisis (cont.)

Russia’s real output growth and inflation, 1991-2003

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-
2003
Real -9.0% -14.5% -8.7% -12.7% -4.1% -3.4% 1.4% -5.3% 6.3% 6.8%
output
growth
Inflation 92.7% 1734.7% 878.8% 307.5% 198.0% 47.7% 14.8% 27.7% 85.7% 18.0%
rate

Source: IMF, World Economic Outlook

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Potential Reforms
Preventative 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. Deposit insurance and reserve requirements
4. Increased credit for troubled banks through the central bank or the IMF?

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