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Chapter 22
Growth, Crisis and Reform
Econ 355
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Introduction
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The macroeconomic problems of the world’s
developing countries affect the stability of the
entire international economy.
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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.
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Example: Causes and effects of the East Asian
financial crisis in 1997
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Structural Features of
Developing Countries
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Most developing countries have at least some of
the following features:
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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
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The Economics of Capital Inflows to
Developing Countries
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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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Developing Country
Borrowing and Debt
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The Problem of Default
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Borrowing by developing countries has
sometimes led to default crises.
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The borrower fails to repay on schedule according to
the loan contract, without the agreement to the lender.
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Developing Country
Borrowing and Debt
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History of capital flows to developing countries:
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Early 19th century
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Throughout the 19th century
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Latin American countries ran into repayment problems (e.g.,
the Baring Crisis).
1917
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A number of American states defaulted on European loans
they had taken out to finance the building of canals.
The new communist government of Russia repudiated the
foreign debts incurred by previous rulers.
Great Depression (1930s)
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Nearly every developing country defaulted on its external
debts.
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Latin America:
From Crisis to Uneven Reform
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Inflation and the 1980s Debt Crisis in Latin
America
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In the 1970s, as the Bretton Woods system
collapsed, countries in Latin America entered an
era of inferior macroeconomic performance.
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Latin America:
From Crisis to Uneven Reform
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Unsuccessful Assaults on Inflation: The
Tablitas of the 1970s
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1978
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Argentina, Chile, and Uruguay all turned to a new
exchange- rate-based strategy in the hope of taming
inflation.
Tablita
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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
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internationally tradableEcon
goods
to force overall inflation down.8
Developing Country
Borrowing and Debt
Figure 22-3: Current Account Deficits and Real Currency Appreciation
in Four Stabilizing Economies, 1976-1997
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Developing Country
Borrowing and Debt
Figure 22-3: Continued
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Developing Country
Borrowing and Debt
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The Debt Crisis of the 1980s
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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:
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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.
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Developing Country
Borrowing and Debt
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Reforms, Capital Inflows, and the Return of
Crisis
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Argentina
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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.
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East Asia: Success and Crisis
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The East Asian Economic Miracle
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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?
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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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East Asia: Success and Crisis
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Asian Weaknesses
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Three weaknesses in the Asian economies’
structures became apparent with the 1997
financial crisis:
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Productivity
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Banking regulation
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Rapid growth of production inputs but little increase in the
output per unit of input
Poor state of banking regulation
Legal framework
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Lack of a good legal framework for dealing with companies
in trouble
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East Asia: Success and Crisis
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The Asian Financial Crisis
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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.
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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.
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Tequila crisis
(December 1994-1995).
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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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East Asia: Success and Crisis
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Crises in Other Developing Regions
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Russia’s Crisis
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1989 – It embarked on transitions from centrally
planned economic allocation to the market.
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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.
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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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East Asia: Success and Crisis
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Argentina’s 2001-2002 crises
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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.
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Lessons of Developing
Country Crises
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The lessons from developing country crises
are summarized as:
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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 contagion
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.
1.
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Defining Contagion
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After controlling for country specific
macroeconomic fundamentals
o
o
o
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The influence of “news” about the creditworthiness,
etc. of a borrower on the spreads charged to the
other borrowers
Excess comovement across countries in asset
returns, whether debt or equity.
An increase in excess comovement in crisis
periods.
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 markets
a. 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”
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The Asian crisis convinced nearly everyone
of an urgent need for rethinking international
monetary relations because of two reasons:
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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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Reforming the World’s
Financial “Architecture”
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Proposals to reform the international
architecture can be grouped as preventive
measures or as ex-post measures.
“Prophylactic” Measures
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Among preventive measures are:
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More “transparency”
Stronger banking systems
Enhanced credit lines
Increased equity capital inflows relative to debt inflows
The effectiveness of these measures is
controversial.
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Reforming the World’s
Financial “Architecture”
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Coping with Crisis
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The ex-post measures that have been suggested
include:
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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.
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Reforming the World’s
Financial “Architecture”
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A Confused Future
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In the years to come, developing countries will
experiment with:
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Floating exchange rates
Capital controls
Currency boards
Abolition of national currencies and adoption of the
dollar or euro for domestic transactions
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Summary
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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.
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The architecture that will ultimately emerge is not
at all clear.
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