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Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 22

DevelopingCountries:

Growth, Crisis,and Reform

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Copyright 2012 Pearson Addison-Wesley. All rights reserved.22-2

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Snapshots of rich and poor countries

Characteristics of poor countries

Borrowing and debt in poor and middle-incomeeconomies

The problem of original sin

Types of financial assets

Latin American, East Asian, and Russian crises

Currency boards and dollarization Lessons from crises and potential reforms

Geographys and human capitals role in poverty

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Rich and Poor

Low income: most sub-Saharan Africa,India, Pakistan

Lower-middle income: China, Caribbean

countries Upper-middle income: Brazil, Mexico, Saudi

Arabia, Malaysia, South Africa, CzechRepublic

High income: U.S., Singapore, France,Japan, Kuwait

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Table 22-1: Indicators of Economic Welfare inFour Groups of Countries, 2008

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Copyright 2012 Pearson Addison-Wesley. All rights reserved. 22-5

Rich and Poor (cont.)

While some previously middle- and low-incomeeconomies have grown faster than high-incomecountries, and thus have caught up with high-income countries, others have languished.

The income levels of high-income countries and somepreviously middle-income and low-income countries haveconverged.

But the some of the poorest countries have had the

lowest growth rates.

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Table 22-2: Output per Capita in SelectedCountries, 19602007 (in 2007 U.S. dollars)

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Table 22-2: Output per Capita in SelectedCountries, 19602007 (in 2007 U.S. dollars)(cont.)

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Characteristics of Poor Countries

What causes poverty?

A difficult question, but low-income countrieshave 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 levelof government purchases relative to GNP

Direct control of financial transactions Reduced competition reduces innovation; lack of market

prices prevents efficient allocation of resources

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Characteristics of Poor Countries (cont.)

2. Unsustainable macroeconomic policies that causehigh inflation and unstable output andemployment If governments cannot pay for debts through taxes, they can

print money to finance debts.

Seigniorageis paying for real goods and services by printingmoney.

Seigniorage generally leads to high inflation.

High inflation reduces the real cost of debt that the governmenthas to repay and reduces the real value of repayments for

lenders. High and variable inflation is costly to society; unstable output

and employment is also costly.

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3. Lack of financial markets that allow transfer offunds from savers to borrowers

4. Weak enforcement of economic laws and

regulations Weak enforcement of property rightsmakes individuals and

institutions less willing to invest in productionprocessesandmakes 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 lawsmakes collection of taxrevenues more difficult, making seigniorage necessary (see 2)and makes tax evasion a problem (see 5).

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Weak enforcement of banking and financial regulations(ex.,lack of examinations, asset restrictions, and capitalrequirements) allows banks and firms to engage in risky or evenfraudulent activities and makes savers less willing to lend tothese institutions.

A lack of monitoring causes a lack of transparency (a lack ofinformation).

Moral hazard: a hazard that a party in a transaction willengage in activities that would be considered inappropriate(ex., too risky or fraudulent) according to another party who

is not fully informed about those activities.

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5. A large underground economy relative to officialGDP 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 othermeasures of education and training: low levels ofhuman capital

Human capital makes workers more productive.

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Fig. 22-1: Corruption and Per CapitaIncome

Source: Transparency International, Corruption Perception Index; World Bank, WorldDevelopment Indicators.

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Borrowing and Debt in Low- and Middle-Income Economies

Another common characteristic for many low- andmiddle-income countries is that they havetraditionally borrowed from foreign countries.

Financial asset flows from foreign countries are able to finance

investment projects, eventually leading to higher productionand consumption.

But some investment projects fail and other borrowed funds areused primarily for consumption purposes.

Some countries have defaulted on their foreign debts when thedomestic economy stagnated or during financial crises.

But this trend has recently reversed as these countries havebegun to save.

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Borrowing and Debt in Low- and Middle-Income Economies (cont.)

national saving investment = the currentaccount

where the current account is approximately equal to thevalue of exports minus the value of imports.

Countries with national saving less than domesticinvestment will have financial asset inflows and anegative current account (a trade deficit).

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Table 22-3: Cumulative Current Account Balances of MajorOil Exporters, Other Developing Countries, and AdvancedCountries, 19732009 (billions of dollars)

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A financial crisis may involve

1. a debt crisis: an inability to repay sovereign(government) or private sector debt.

2. a balance of payments crisisunder a fixed exchange

rate system.3. a banking crisis: bankruptcy and other problems for

private sector banks.

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A debt crisis in which governments default on theirdebt can be a self-fulfilling mechanism.

Fear of default reduces financial asset inflows andincreases financial asset outflows(capital flight),

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

Financial asset outflows must be matched with an increasein net exports or a decrease in official internationalreserves in order to pay individuals and institutions who

desire foreign funds.

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Otherwise, the country cannot afford to pay those whowant to remove their funds from the domestic economy.

The domestic government may have no choice but todefault on its sovereign debt (paid for with foreign funds)when it comes due and when investors are unwilling toreinvest.

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In general, a debt crisis can quickly magnify itself:it causes low income and high interest rates, whichmake government and private sector debts evenharder to repay.

High interest rates cause high interest payments for boththe government and the private sector.

Low income causes low tax revenue for the government.

Low income makes loans made by private banks harder to

repay: the default rate increases, which may causebankruptcy.

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If the central bank tries to fix the exchange rate, abalance of payment crisismay result along with adebt crisis. Official international reserves may quickly be depleted

because governments and private institutions need to payfor their debts with foreign funds, forcing the central bankto abandon the fixed exchange rate.

A banking crisismay result from a debt crisis. High default rates on loans made by banks reduce their

income to pay for liabilities and may increase bankruptcy.

If depositors fear bankruptcy due to possible devaluation ofthe currency or default on government debt (assets forbanks), then they will quickly withdraw funds from banks(and possibly purchase foreign assets), leading to actualbankruptcy.

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A debt crisis, a balance of payments crisis, and abanking crisis can occur together, and each canmake the other worse.

Each can cause aggregate demand, output, andemployment to fall (further).

If people expecta default on sovereign debt,a currency devaluation, or bankruptcy of private

banks, each can occur, and each can lead toanother.

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The Problem of Original Sin

Sovereign and private sector debts in the U.S.,Japan, and European countries are mostlydenominated in their respective currencies.

But when poor and middle-income countries

borrow in international financial capital markets,their debts are almost always denominated inU.S.$, yen, or euros: a condition called originalsin.

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The Problem of Original Sin(cont.)

When a depreciation of domestic currencies occursin the U.S., Japan, or European countries, liabilities(debt) that are denominated in domesticcurrenciesdo not increase, but the value of foreign assets

increases. A devaluation of the domestic currency causes an increasein net foreign wealth.

When a depreciation/devaluation of domesticcurrencies occurs in most poor and middle-income

economies, the value of their liabilities (debt) risesbecause their liabilities are denominated in foreigncurrencies. A devaluation of the domestic currency causes a decrease

in net foreign wealth.

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The Problem of Original Sin(cont.)

In particular, a fall in aggregate demand of domesticproducts causes a depreciation/devaluation of thedomestic currency and causes a decrease in net foreignwealth if assets are denominated in domestic currenciesand liabilities (debt) are denominated in foreign

currencies.

This is a situation of negative insurance against a fall inaggregate demand.

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Types of Financial Assets

1. Bond finance:government or private sectorbonds are sold to foreign individuals andinstitutions.

2. Bank finance:commercial banks or securities

firms lend to foreign governments or foreignbusinesses.

3. Official lending:the World Bank, Inter-AmericanDevelopment Bank, or other official agencies lendto governments.

Sometimes these loans are made on a concessional orfavorable basis, in which the interest rate is low.

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Types of Financial Assets (cont.)

4. Foreign direct investment:a firm directlyacquires or expands operations in a subsidiaryfirm in a foreign country.

A purchase by Ford of a subsidiary firm in Mexico isclassified as foreign direct investment.

5. Portfolio equity investment:a foreign investorpurchases equity (stock) for his portfolio.

Privatization of government-owned firms in manycountries has created more equity investmentopportunities for foreign investors.

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Types of Financial Assets (cont.)

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 valueof equity finance fluctuates depending on

aggregate demand and output.

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Latin American Financial Crises

In the 1980s, high interest rates and anappreciation of the U.S. dollar caused the burdenof dollar-denominated debts in Argentina, Mexico,Brazil, and Chile to increase drastically.

A worldwide recession and a fall in manycommodity prices also hurt export sectors in thesecountries.

In August 1982, Mexico announced that it couldnot repay its debts, mostly to private banks.

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Latin American Financial Crises (cont.)

The U.S. government insisted that the privatebanks reschedulethe debts, and in 1989 Mexicowas 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 alsoallowed to reschedule their debts with privatebanks after they defaulted.

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The Mexican government implemented severalreforms due to the crisis. Starting in 1987, it

reduced government deficits.

reduced production in the public sector (including

banking) by privatizing industries.

reduced barriers to trade.

maintained an adjustable fixed exchange rate (crawlingpeg) until 1994 to help curb inflation.

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It extended credit to newly privatized banks withloan losses.

Losses were a problem due to weak enforcement or lackof asset restrictions and capital requirements.

Political instability and loan defaults at privatebanks contributed to another crisis in 1994, afterwhich the Mexican government allowed the valueof the peso to fluctuate.

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Starting in 1991, Argentina carried out similarreforms:

It reduced government deficits.

It reduced production in the public sector by privatizingindustries.

It reduced barriers to trade.

It enacted tax reforms to increase tax revenues.

It enacted the Convertibility Law, which required thateach peso be backed with 1 U.S. dollar, and it fixed theexchange rate to 1 peso per U.S. dollar.

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Because the central bank was not allowed to printmore pesos without having more dollar reserves,inflation slowed dramatically.

Yet inflation was about 5% per annum, faster than

U.S. inflation, so that the price/value ofArgentinean goods appreciated relative to U.S.and other foreign goods.

Due to the relatively rapid peso price increases,

markets began to speculate about a pesodevaluation.

A global recession in 2001 further reduced thedemand of Argentinean goods and currency.

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Maintaining the fixed exchange rate was costlybecause high interest rates were needed to attractinvestors, further reducing investment andconsumption expenditure, output, and

employment.

As incomes fell, tax revenues fell and governmentspending rose, contributing to further pesoinflation.

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Argentina tried to uphold the fixed exchange rate,but the government devalued the peso in 2001and shortly thereafter allowed its value tofluctuate.

It also defaulted on its debt in December 2001because of the unwillingness of investors toreinvest when the debt was due.

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Brazil carried out similar reforms in the 1980s and1990s:

It reduced production in the public sector by privatizingindustries.

It reduced barriers to trade.

It enacted tax reforms to increase tax revenues.

It fixed the exchange rate to 1 realperU.S. dollar.

But government deficits remained high.

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High government deficits led to inflation andspeculation about a devaluation of the real.

The government did devalue the realin 1999, but

a widespread banking crisis was avoided becauseBrazilian banks and firms did not borrowextensively in dollar-denominated assets.

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Chile suffered a recession and financial crisis inthe 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 controls on flows of short-term assets, so thatfunds could not be quickly withdrawn during a financialpanic.

granted the central bank independence from fiscalauthorities, allowing slower money supply growth.

Chile avoided a financial crisis in the 1990s.

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East Asian Financial Crises

Before the 1990s, Indonesia, Korea, Malaysia,Philippines, and Thailand relied mostly ondomestic saving to finance investment.

But afterwards, foreign funds financed much ofinvestment, and current account balances turnednegative.

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East Asian Financial Crises (cont.)

Despite the rapid economic growth in East Asiabetween 1960 and 1997, growth was predicted toslow as economies caught up with Westerncountries.

Most of the East Asian growth during this period isattributed to an increase in physical capital and education.

The marginal productivities of physical capital andeducation are diminishing: as more physical capital was

built and as more people acquired more education, furtherincreases added less productive capability to the economy.

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More directly related to the East Asian crises areissues related to economic laws and regulations:

1. Weak enforcement of financial regulations and a

lack of monitoring caused commercial firms,banks, and borrowers toengageinrisky or evenfraudulent activities: moral hazard.

Ties between commercial firms and banks on the onehand and government regulators on the other hand

allowed risky investments to occur.

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2. Nonexistent or weakly enforced bankruptcy lawsand loan contracts worsened problems after thecrisis started.

Financially troubled firms stopped paying their debts,

and they could not operate without cash, but no onewould lend more until previous debts were paid.

But creditors lacked the legal means to confiscate andsell assets to other investors or to restructure the firmsto make them productive again.

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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 investor andexport market, also contributed to the economicslowdown.

Speculation about a devaluation of the baht occurred, andin July 1997 the government devalued the baht slightly,but this only invited further speculation.

Malaysia, Indonesia, Korea, and the Philippinessoon faced speculations about the value of theircurrencies.

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Most debts of banks and firms were denominatedin U.S. dollars, so that devaluations of domesticcurrencies would make the burden of the debts indomestic currency increase.

Bankruptcy and a banking crisis would have resulted.

To maintain fixed exchange rates would haverequired high interest rates and a reduction ingovernment deficits, leading to a reduction in

aggregate demand, output, and employment.

This would have also led to widespread default on debtsand a banking crisis.

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All of the affected economies except Malaysiaturned to the IMF for loans to address the balanceof payments crises and to maintain the value ofthe 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.

Malaysiainsteadimposedcontrolsonflowsof

financial assets so that it could increase its moneysupply (and lower interest rates), increasegovernment purchases, and still try to maintainthe value of the ringgit.

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Table 22-4: East Asian CA/GDP (annualaverages, percent of GDP)

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Russias Financial Crisis

After liberalization in 1991, Russias economic lawswere weakly enforced or nonexistent.

There was weak enforcement of banking regulations, taxlaws, 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 seigniorage.

Interest rates rose on government debt to reflect highinflation from seigniorage and the risk of default.

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Russias Financial Crisis (cont.)

The IMF offered loans of official internationalreserves to try to support the fixed exchange rateconditional on reforms.

But in 1998, Russia devalued the ruble and

defaulted on its debt and froze financial assetflows.

Without international financial assets forinvestment, output fell in 1998 but recovered

thereafter, partially due to the expandingpetroleum industry.

Inflation rose in 1998 and 1999 but fell thereafter.

T bl 22 5 R l O t t G th d

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Table 22-5: Real Output Growth andInflation: Russia and Poland, 19912003(percent per year)

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Currency Boards and Dollarization

A currency boardis a monetary policy where the moneysupply is entirely backed by foreign currency, and where thecentral bank is prevented from holding domestic assets.

The central bank may not increase the domestic money supplyby buying government bonds.

This policy restrains inflation and government deficits.

The central bank also cannot run out of foreign reserves tosupport a fixed exchange rate.

Argentina enacted a currency board under the 1991

Convertibility Law.

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Currency Boards and Dollarization (cont.)

But a currency board can be restrictive (more than a regularfixed exchange rate system).

Since the central bank may not acquire domestic assets,it cannot lend currency to domestic banks duringfinancial crisis: no lender of last resort policy or seigniorage.

Dollarizationis a monetary policy that replaces the domesticcurrency in circulation with U.S. dollars.

In effect, control of domestic money supply, interest rates, andinflation is given to the Federal Reserve System.

A lender of last resort policy and the possibility of seigniorage fordomestic policy makers are eliminated.

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Lessons of Crises

1. Fixing the exchange rate has risks: governmentsdesire to fix exchange rates to provide stability inthe export and import sectors, but the price to paymay be high interest rates or high unemployment.

High inflation (caused by government deficits or increasesin the money supply) or a drop in demand of domesticexports leads to an overvalued currency and pressure fordevaluation.

Given pressure for devaluation, commitment to a fixedexchange rate usually means high interest rates (areduction in the money supply) and a reduction indomestic prices.

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Lessons of Crises (cont.)

Prices can be reduced through a reduction in governmentdeficits, leading to a reduction in aggregate demand,output, and employment.

A fixed currency may encourage banks and firms to

borrow in foreign currencies, but a devaluation will causean increase in the burden of this debt and may lead to abanking crisis and bankruptcy.

Commitment a fixed exchange rate can cause a financialcrisis to worsen: high interest rates make loans for

individuals and institutions harder to repay, and thecentral bank cannot freely print money to give to troubledbanks (cannot act as a lender of last resort).

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2. Weak enforcement of financial regulations canlead to risky investments and a banking crisiswhen a currency crisis erupts or when a fall inoutput, income, and employment occurs.

3. Liberalizing financial asset flows withoutimplementing sound financial regulations canlead to capital flight when investments lose valueduring a recession.

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4. The importance of expectations: even healthyeconomies are vulnerable to crises whenexpectations 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 inother countries.

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5. The importance of having adequate officialinternational reserves:

Official international reserves are needed not just for acurrent account deficit, but more importantly to protect

against capital flight due to speculation andexpectations about financial crises.

China, Russia, India, Brazil, and other countries haveincreased their holdings of official international reservessince their crises.

Countries that maintain fixed exchange rates, like China,have an additional reason to hold large quantities ofreserves.

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Potential Reforms: Policy Trade-offs

Countries face tradeoffs when trying to achievethe following goals:

exchange rate stability

financial capital mobility

autonomous monetary policy devoted to domestic goals

Generally, countries can attain only 2 of the 3goals, and as financial assets have become moremobile, maintaining a fixed exchange with an

autonomous monetary policy has been difficult.

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Potential Reforms

Preventative measures:

1. Better monitoring and more transparency: moreinformation allows investors to make sound financialdecisions in good and bad times.

2. Stronger enforcement of financial regulations: reducesmoral hazard.

3. Deposit insurance and reserve requirements.

4. Increased equity finance relative to debt finance.

5. Increased credit for troubled banks through central banksor the IMF?

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Potential Reforms (cont.)

Reforms for after a crisis occurs:

1. Bankruptcy procedures for default on sovereign debt andimproved bankruptcy law for private sector debt.

2. A bigger or smaller role for the IMF as a lender of lastresort for governments, central banks, and even theprivate sector? (See 5 above.)

Moral hazard versus the benefit of insurance before andafter a crisis occurs.

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Chinas Currency

China has tried to maintain a fixed exchange rate to promoteits exports.

The value of its renminbi has been kept low relative to the U.S.dollar so that its goods are not expensive in U.S. markets.

Exports have surged and imports have been low because of an

undervalued renminbi and because Chinese citizens save a lot. Because of Chinas large current account surplus and

because of large amounts of financial asset inflows, foreignassets held by the central bank have grown substantially.

Some foreign investors who have bought Chinese assets did so

from speculation that the renminbi will be revalued.

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Chinas Currency (cont.)

As the central bank purchased foreign assets, the domesticmoney supply has grown substantially, resulting in inflation.

To moderate inflation and political pressure about tradesurpluses, the Chinese central bank has gradually allowedthe value of the renminbi to increase relative to the U.S.

dollar. A more valuable renminbi allows Chinese buyers to afford to

spend more on imports, so that the large current accountsurpluses and the excessive amount of saving can be reduced.

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Fig. 22-3: Rebalancing Chinas Economy

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Geography Human Capital and

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Geography, Human Capital, andInstitutions (cont.)

Geography matters:

1. International trade is important for growth, and oceanharbors and a lack of geographical barriers foster trade withforeign markets.

Landlocked and mountainous regions are predicted tobe poor.

2. Also, geography is said to have determinedinstitutions,which may play a role in development.

Geography determined whether Westerners establishedproperty rights and long-term investment in colonies, which in

turn influenced economic growth.

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Geography Human Capital and

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Geography, Human Capital, andInstitutions (cont.)

Human capital matters:

1. As a population becomes more literate, numerate, andeducated, economic and political institutions evolve tofoster long-term economic growth.

Rather than geography, Western colonization, and plantationagriculture, the amount of education and other forms ofhuman capital determine the existence or lack of propertyrights, financial markets, international trade, and otherinstitutions that encourage economic growth.

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Summary

1. Some countries have grown rapidly since 1960, but othershave stagnated and remained poor.

2. Many poor countries have extensive government control ofthe economy, unsustainable fiscal and monetary policies,lack of financial markets, weak enforcement of economiclaws, a large amount of corruption, and low levels ofeducation.

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Summary (cont.)

3. Many developing economies have traditionally borrowedfrom international capital markets, and some have sufferedfrom periodic sovereign debt crises, balance of paymentscrises, and banking crises.

4. Sovereign debt, balance of payments, and banking crisescan be self-fulfilling, and each crisis can lead to anotherwithin a country or in another country.

5. Original sin refers to the fact that poor and middle-income countries often cannot borrow in their domestic

currencies.

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Summary (cont.)

6. A currency board fixes exchange rates by backing up eachunit of domestic currency with foreign reserves.

7. Dollarization is the replacement of domestic currency incirculation with U.S. dollars.

8. Fixing exchange rates may lead to financial crises if thecountry is unwilling to restrict monetary and fiscal policies.

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Summary (cont.)

9. Weak enforcement of financial regulations causes a moralhazard and may lead to a banking crisis, especially withfree movement of financial assets.

10. Geography and human capital may influence economic andpolitical institutions, which in turn may affect long-termeconomic growth.

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M22_Krugman_46657_09_IE_C22_F