Chapter 22: Developing Country Issues, Part 1

Chapter 22: Developing Country Issues, Part 1

Topics:

Macroeconomic features

Debt and debt crisis

Mexican peso crisis

Introduction: The issues we have discussed so far have all related to the developed countries in the world. But many of the dramatic developments in the international macroeconomy in recent decades have taken place in the developing countries.

We begin by characterizing how the macro-economies in these countries typically are different from those in the U.S. or other developed countries. Then we consider various crises that have occurred in developing countries.

1. Macroeconomic features

a) Undeveloped financial markets:

Usually developing countries do not have the broad and rapidly adjusting financial markets that exist in the U.S. Stock markets usually are very small if they exist at all, and there aren’t markets for long-term debt contracts. This limits the options for firms who wish to borrow, say to carry out investment projects.

There is bank lending, but it is typically tightly controlled by the government. Often national law keeps interest rates artificially low, so as to subsidize favored industries or sectors in the economy. Low interest rates mean there is a shortage of saving and excess demand for borrowing, so government allocates capital to the preferred sectors.

There is often Capital flight: flow of private funds into foreign assets, because low interest rates at home or fear financial instability like currency crises.

b) Government’s pervasive role

State enterprises: Many companies are owned and managed by the national government. For example, state companies produce half of the Brazilian GNP. Recently there has been a trend of some privatization in some developing countries. Privatization occurs when a government sells state-owned enterprises to private sector or foreign investors, either to help efficiency or to generate government revenue.

c) Seigniorage (inflation tax)

With undeveloped financial markets, it is hard for a government to pay for a deficit by selling its bonds. One alternative is to borrow from foreign banks or sell bonds abroad. Another alternative is to print the money it needs, since it controls the printing presses.

Def: Seigniorage is the real output that a government obtains by printing money and spending it.

Clearly an increase in the money supply will lead to inflation. So for everyone who was holding money, the inflation lowers the real value of this money in terms of what you can buy with it. So the inflation associated with seigniorage acts like a tax on all money holdings.

Example: Suppose the Brazilian government doubles the money supply from 1 trillion reals to two, and the price level doubles. The real value of the increased money supply is what one trillion reals would buy now, or what half a trillion reals could buy before the money supply increase. So the 1 trillion reals that people were holding lose half of their value. Effectively, there is a tax: here the seignorage tax is what half a trillion reals could have bought.

This inflation tax does occur in the U.S. but it is small. For example in 1980-1985, the U.S. had average inflation of 7%, meaning seigniorage averaging 0.3% of GNP. In contrast, in Argentina 1980-85, inflation was 274 %, with seigniorage equal to 4% of GNP; in Bolivia, this was 500% inflation and 6.2 percent of GNP.

d) Exchange rates

Developing countries seem to often have fixed exchange rates. Even more, they often set controls on foreign exchange transactions, and use multiple exchange rates for commercial policy: to subsidize imports of certain sectors, like machinery for investment, while discouraging imports of luxury consumption goods. This results in a black market in currencies.

Crawling peg: Because high seigniorage and inflation make a fixed exchange rate not sustainable, often have a system of adjusting the peg frequently, even daily.

e) Exports

These are usually focused on a small number of natural resources or agricultural products. So these countries tend to be highly susceptible to change in world demand and the price of a primary export good. Raw materials are especially prone to such shocks.

This can be analyzed as a negative taste shock - a shift left in the DD curve. This would lead to internal and external imbalance, with low output and a big CA deficit.

1. Debt and Debt Crisis

a) Features of Borrowing

We stated above that underdeveloped financial markets tend to make saving rates low in developing countries. But because a country is not yet developed, there may be many profitable investment opportunities - there is a large pool of labor with a shortage of capital equipment. Building a factory could be very profitable.

On the other hand, the developed countries (where the rich lodes may already be mined) often have higher savings levels. So there can be good reasons to have a flow of financial capital from rich countries to poor. Foreign money finances the investment, in exchange for part of profits that the investments generate.

b) Forms taken by the capital inflows

1. Bond finance: government sells bonds to private foreign citizens (esp. interwar years)
2. Bank loans: government borrow from banks in developed countries. (esp. since 1970s)
3. Direct foreign investment: a foreign firm buys a subsidiary in the country. For example, Volkswagen building a plant in Mexico (this was important until the 1970’s, then declined until the 1990’s, and has recently become important again.).
4. Portfolio investment: buy shares in stocks on the developing country’s stock exchange, a very recent development enhanced by the privatization trend.
5. Official lending - borrow from IMF or World Bank.

Note that most debt involves the government either directly or as a repayment guarantor.

Discuss equity vs. debt financing

c) Early History

Pre-WWI years: there was a high level of capital flows from Europe to developing countries of that time, including the US, Canada, Australia, Argentina. (in the 19thcentury, Argentina had a higher per capita income than Canada!). Up to 40% of Britain’s savings flowed to foreign investment. But the international capital flows shrank after the great depression began.

d) Roots of the crisis

The OPEC oil shock made the oil-producing countries (at least temporarily) rich. They deposited these funds in foreign banks in the U.S. and other developed countries (a lot went to British banks). These banks had to look for profitable opportunities to invest these funds- recycle funds (too many loose dollars looking for a home). So they loaned to non-oil producing developing countries. Before then, banks had not played a big role in international lending. Many of these loan contracts were floating rate loan contracts, where the interest rate was indexed to some other market rate.

But in the early 1980’s, the U.S. responded to the inflation of second oil crisis by cutting the money supply – and this led to a rise in interest rate and an appreciation of dollar. In turn, developing-country debt became more costly to service. In addition, loans were denominated in dollars, so their cost in terms of domestic currency went up.

Developing countries thought this was a temporary situation, so they borrowed more to be able to make their current interest payments. There was also a large recession in developing countries in the early 1980s. This worsened the crisis for developing countries because it cut demand for their exports.

e) The crisis hits

In 1982 Mexico announced it could not meet its scheduled payments because it had nearly run out of reserves of the currencies in which it was required to make payment. Its government requested special loans from governments and the IMF, a moratorium on repayments of principal to commercial banks, and a rescheduling of payments.

Naturally, the commercial banks panicked. They feared that other developing countries would not be able to make payments, so they stopped lending to others, like Brazil and Argentina, even to renew short-term debt. Cut off from flow of funds, these countries too were in crisis.

Put into a position where they couldn’t even roll over-short term debt, the countries were asked to repay the whole accumulated debt right away. This was impossible to do, so other countries also had to default on their financial obligations. When a country decides not to pay its debt, this is called sovereign default.

While this has the benefit of relieving the country of a big expense, it also has costs:

1. seizure of assets
2. exclusion from future borrowing (for a while anyway, short memories)
3. can’t easily engage in international trade, since it is has no credit to use to arrange purchases

f) IMF role

Recall that under Bretton Woods, the IMF loaned reserve currencies to help countries maintain a fixed exchange rate level. After the fall of the Bretton Woods system, the IMF had to find a new mission for itself. The debt crisis provided a role for it to play. It tried to ease the debt crisis by extending loans to countries unable to get loans from private sources.

It would extend loans with conditions. IMF conditionality often included macroeconomic stabilization programs: cut money creation, cut government expenditure and reliance on seigniorage revenue, improve the current account, etc. Because of IMF demands, countries often cut popular government programs, such as subsidies for basic food goods. This made the IMF quite unpopular in developing countries under their influence.

But conditionality also served a role to reassure private banks that policies in the country were being altered to make them less risky customers. The IMF also worked to coordinate bank lending by private banks to the countries.