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Chapter 22

Growth, Crisis and Reform

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Introduction The macroeconomic problems of the world’s

developing countries affect the stability of the entire international economy. There has been greater economic dependency

between developing and industrial countries since WWII.

This chapter examines the macroeconomic problems of developing countries and the repercussions of those problems on the developed countries. Example: Causes and effects of the East Asian

financial crisis in 1997

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Structural Features of Developing Countries

Most developing countries have at least some of the following features:

History of extensive direct government control of the economy

History of high inflation reflecting government attempts to extract seigniorage from the economy

Weak credit institutions and undeveloped capital markets Pegged exchanged rates and exchange or capital controls Heavy reliance on primary commodity exports High corruption levels

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Developing Country Borrowing and Debt

The Economics of Capital Inflows to Developing Countries Many developing counties have received

extensive capital inflows from abroad and now carry substantial debts to foreigners.

Developing country borrowing can lead to gains from trade that make both borrowers and lenders better off.

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The Problem of Default Borrowing by developing countries has

sometimes led to default crises. The borrower fails to repay on schedule according to

the loan contract, without the agreement to the lender.

Developing Country Borrowing and Debt

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History of capital flows to developing countries: Early 19th century

A number of American states defaulted on European loans they had taken out to finance the building of canals.

Throughout the 19th century Latin American countries ran into repayment problems (e.g.,

the Baring Crisis). 1917

The new communist government of Russia repudiated the foreign debts incurred by previous rulers.

Great Depression (1930s) Nearly every developing country defaulted on its external

debts.

Developing Country Borrowing and Debt

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Latin America: From Crisis to Uneven Reform

Inflation and the 1980s Debt Crisis in Latin America In the 1970s, as the Bretton Woods system

collapsed, countries in Latin America entered an era of inferior macroeconomic performance.

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Unsuccessful Assaults on Inflation: The Tablitas of the 1970s 1978

Argentina, Chile, and Uruguay all turned to a new exchange- rate-based strategy in the hope of taming inflation.

Tablita It is a preannounced schedule of declining rates of domestic

currency depreciation against the U.S. dollar. It is a type of exchange rate regime known as a crawling

peg. It declined the rate of currency depreciation against the

dollar by reducing the rate of increase in the prices of internationally tradable goods to force overall inflation down.

Latin America: From Crisis to Uneven Reform

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Figure 22-3: Current Account Deficits and Real Currency Appreciation in Four Stabilizing Economies, 1976-1997

Developing Country Borrowing and Debt

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Developing Country Borrowing and Debt

Figure 22-3: Continued

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The Debt Crisis of the 1980s The great recession of the early 1980s sparked a crisis

over developing country debt. The shift to contractionary policy by the U.S. led to:

The fall in industrial countries' aggregate demand An immediate and spectacular rise in the interest burden

debtor countries had to pay A sharp appreciation of the dollar A collapse in the primary commodity prices

The crisis began in August 1982 when Mexico’s central bank could no longer pay its $80 billion in foreign debt.

By the end of 1986 more than 40 countries had encountered several external financial problems.

Developing Country Borrowing and Debt

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Reforms, Capital Inflows, and the Return of Crisis Argentina

1970s – It tried unsuccessfully to stabilize inflation through a crawling peg.

1980s – It implemented successive inflation stabilization plans involving currency reforms, price controls, and other measures.

1990s – It adopted a currency board (peso-dollar peg).

2001-2002 – It defaulted on its debts and abandoned the peso-dollar peg.

Developing Country Borrowing and Debt

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East Asia: Success and Crisis

The East Asian Economic Miracle Until 1997 the countries of East Asia were having

very high growth rates. What are the ingredients for the success of the

East Asian Miracle? High saving and investment rates Strong emphasis on education Stable macroeconomic environment Free from high inflation or major economic slumps High share of trade in GDP

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East Asia: Success and Crisis

Table 22-4: East Asian CA/GDP

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Asian Weaknesses Three weaknesses in the Asian economies’

structures became apparent with the 1997 financial crisis: Productivity

Rapid growth of production inputs but little increase in the output per unit of input

Banking regulation Poor state of banking regulation

Legal framework Lack of a good legal framework for dealing with companies

in trouble

East Asia: Success and Crisis

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The Asian Financial Crisis It stared on July 2, 1997 with the devaluation of the

Thai baht. The sharp drop in the Thai currency was followed

by speculation against the currencies of: Malaysia, Indonesia, and South Korea. All of the afflicted countries except Malaysia turned to

the IMF for assistance. The downturn in East Asia was “V-shaped”: after

the sharp output contraction in 1998, growth returned in 1999 as depreciated currencies spurred higher exports.

East Asia: Success and Crisis

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Tequila crisis (December 1994-1995).

In late 1994 a large current account deficit, a weak banking system, and rapid growth in dollar-indexed Mexican government debt (Cetes) led to a large devaluation and depreciation of the Mexican peso and a financial crisis as foreign investors refused to buy new Cetes. Contagion (the "tequila effect") spread the crisis to other Latin American countries.

In early 1995, speculative attacks spread to other Latin American countries - Argentina went into a sharp recession

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East Asia: Success and Crisis

Table 22-5: Growth and the Current Account, Five Asian Crisis Countries

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Crises in Other Developing Regions Russia’s Crisis

1989 – It embarked on transitions from centrally planned economic allocation to the market. These transitions involved: rapid inflation, steep output

declines, and unemployment. 1997 – It managed to stabilize the ruble and reduce

inflation with the help of IMF credits. 2000 – It enjoyed a rapid growth rate.

East Asia: Success and Crisis

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East Asia: Success and Crisis

Table 22-6: Real Output Growth and Inflation: Russia and Poland, 1991-2000 (percent per year)

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Argentina’s 2001-2002 crises Its rigid peg of its peso to the dollar proved painful as

the dollar appreciated in the foreign exchange market. 2001 – It restricted residents’ withdrawals from banks

in order to stem the run on the peso, and then it stopped payment on its foreign debts.

2002 – It established a dual exchange rate system and a single floating-rate system for the peso.

East Asia: Success and Crisis

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Lessons of Developing Country Crises

The lessons from developing country crises are summarized as: Choosing the right exchange rate regime The central importance of banking The proper sequence of reform measures The importance of contagion

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Defining contagion1. Some papers have defined contagion as the influence of “news”

about the creditworthiness, etc. of a borrower on the spreads charged to the other borrowers or equity prices, after controlling for country specific macroeconomic fundamentals (Doukas, 1989,Kaminsky and Schmukler, 1998)

2. Other studies, such as Valdes (1995), defined contagion as excess comovement across countries in asset returns, whether debt or equity. The comovement is said to be excessive if it persists even after common fundamentals, as well as idiosyncratic factors, have been controlled for.

3. A recent variant to this approach is presented in Arias, Haussmann, and Rigobon (1998) and Forbes and Rigobon (1998), who define contagion more narrowly by requiring an increase in excess comovement in crisis periods.

4. Eichengreen, Rose, and Wyplosz (1996) defined contagion as a case where knowing that there is a crisis elsewhere increases the probability of a crisis at home, even when fundamentals have been properly taken into account.

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Defining Contagion

After controlling for country specific macroeconomic fundamentalso The influence of “news” about the creditworthiness,

etc. of a borrower on the spreads charged to the other borrowers

o Excess comovement across countries in asset returns, whether debt or equity.

o An increase in excess comovement in crisis periods.o A case where knowing that there is a crisis

elsewhere increases the probability of a crisis at home

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Contagion

1. Why does contagion arise? What are the channels of transmission?

2. Who is vulnerable to sudden reversals of capital flows and contagion?

3. What does the empirical evidence reveal on these issues?

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Contagion

Contagion may and usually does intensify during periods of turbulence–but it is not limited to those episodes

The evidence suggests that asset prices (bond yields, stock prices, commodity prices) and capital flows exhibit “excess comovement.”

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Table on stock co-movement

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What are the channels of transmission?

1. Trade channels and exchange rate pressures. a. It could be bilateral trade (ex. Chile 1997-98) b. or competition for trade with a common third partner (ex. East Asia’s trade with Japan)

2. Integrated financial marketsa. Banks are interconnected through loans (Mexican Banks

were extending trade credit to Costa Rican banks prior to the 1994 crisis)b. Interconnection through bond holdings. (Korea was

holding Brazilian and Russian bonds)c. Liquidity management practices of open end mutual

funds (Thai share prices fall–sell Indonesia).

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What are the channels of transmission?

3. The weakening finances of a common creditor (US banks in early 1980s and Japanese banks in 1990s)

4. Reassesment of risk (and/or risk increased risk aversion)–the “wake up call” hypothesis. Possibly affecting countries with similar fundamentals.

5. Information asymmetries

6. Political contagion

7. Herding behavior

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Possible channels of transmission

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Who is most vulnerable to sudden reversals of capital flows and contagion?

1. Large current account deficits?

2. Substantial real exchange rate appreciation?

3. No capital account barriers?

4. Fixed exchange rate?

5. Weak banking system?

6. “Bad” composition of capital inflows–too much short

term debt?

7. Lack of credibility–poor macroeceonomic track

record?

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Reforming the World’s Financial “Architecture”

The Asian crisis convinced nearly everyone of an urgent need for rethinking international monetary relations because of two reasons: The fact that the East Asian countries had few

apparent problems before their crisis struck The apparent strength of contagion through the

international capital markets

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Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures.

“Prophylactic” Measures Among preventive measures are:

More “transparency” Stronger banking systems Enhanced credit lines Increased equity capital inflows relative to debt inflows

The effectiveness of these measures is controversial.

Reforming the World’s Financial “Architecture”

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Coping with Crisis The ex-post measures that have been suggested

include: More extensive lending by the IMF “Chapter 11” bankruptcy proceeding for the orderly

resolution of creditor claims on developing countries that cannot pay in full.

Reforming the World’s Financial “Architecture”

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A Confused Future In the years to come, developing countries will

experiment with: Floating exchange rates Capital controls Currency boards Abolition of national currencies and adoption of the

dollar or euro for domestic transactions

Reforming the World’s Financial “Architecture”

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Summary

Despite their excellent records of high output growth and low inflation, key developing countries in East Asia were hit by currency depreciation in 1997.

Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures. The architecture that will ultimately emerge is not

at all clear.