Foreign Debt and Financial Crises Dr. George Norton Agricultural and Applied Economics Virginia Tech Copyright 2009 AAEC 3204

Objectives Discuss causes and effects of Long-term debt and short-term financial crises in developing countries Causes Effects on developing and developed countries Solutions

Debt is to Some Extent Normal Going into debt is normal for developing country governments Because: Many pressing needs, yet limited revenues Many opportunities for productive investments yet little capital relative to labor International capital flows for private investment in developing countries is also normal due to those opportunities

However, Debt Has Become Excessive Heavy borrowing in developing countries, particularly in Latin America and Africa, from 1973 to 1981 (public and private debt) Crisis due to difficulty of paying off debts began in 1982 Lower incomes as a result in developing countries, over-extended banks in developed countries, and trade effects

Debt problem: What has happened since crisis began in 1982? Officials and large banks rescheduled some debts Some writing down and (recently some) forgiveness of debts IMF has required structural changes for new lending Imports in developing countries down, exports up, poverty up

Indicators of external debt for specific developing countries Source: World Bank, World Development Report, various years. Country or Country Group Total External Debt as a Percent of Gross National Income Low income Middle income Argentina Brazil Morocco Philippines

What is a structural adjustment program? What changes occur? Who benefits and who is hurt? What is the IMF and how does it get involved?

What is the “Paris Club”? The Paris Club is a forum for negotiations on countries’ debts to government creditors. The participants in any Paris Club negotiation are the debtor government and its creditors, who traditionally meet under the chairmanship of a senior French treasury official. Debtor countries approaching the Paris Club are usually required to conclude an agreement with the IMF for an IMF loan and an IMF-approved program for restructuring economic policies such as reductions in government spending and fewer restrictions on exports.

What is the “Secondary Market” for Debt? Debt can be shifted from bank to bank or to other institutions, in other words sold at a discount because creditors believe they will not be repaid in full. For example, each dollar of Peru’s debt sold for about 5 cents on the secondary market in 1991.

Potential solutions to debt problem Free up markets in developing countries to encourage exports from developing countries Write down or forgive debts (especially for least developed countries) Reduce and fix interest rates Reschedule debts by extending repayment period Lower trade barriers to developing countries Bond schemes (conversion of bank loans into bonds with reduced principal or interest backed by IMF) Debt for equity or debt for conservation swaps New loans and cash buybacks of old loans

Major Attempts at Solving Debt Problem (Middle income countries) Baker Plan(s) (1980s) – Freer markets, debt rescheduling by World Bank and others, bonds backed by U.S. treasury Brady Plan (1989) – Freer markets, writing down about 20% of principal, conversion of bank loans into new bonds with reduced principal or interest rates (backed by IMF and World Bank), debt buybacks for cash, debt for equity swaps (16 countries)

Major Attempts at Solving Debt Problem (For Poorest Countries) Heavily Indebted Poor Countries (HIPC) Initiative – IMF and World Bank plan for 38 countries, mostly in Africa (1996) Partially forgive debts if countries follow pro-poor growth policies Multi-Lateral Debt Relief Initiative (MDRI) (2005) – G8 Gleneagles plan Complete debt forgiveness for poorest countries – Issue of small funding commitment

Short-term Financial Crises What are they? Why do they occur? Where have they occurred in past 10 years? What are the effects? What can countries or the international community do to avoid them?

Where have Financial crises occurred Latin America, East Asia, 1997 Russia, 1998 Brazil, Argentina, Turkey 2000 Differences but many similarities: Large capital inflows in preceding years Exchange rates had appreciated Large current account deficits

Crisis Situation Rapid devaluation of currency Capital flight Asset values depreciated Real income dropped sharply Contagion IMF response: credit linked to restructuring

Example: Asian Financial Crisis (1997) Squandering of cheap capital on risky loans Overvalued pegged exchange rates Liberalized rules on foreign borrowing Inflated asset prices Lax financial supervision People expected government bailout The financial bubble burst First in Thailand, then Philippines, Malaysia, Indonesia, and South Korea

How did bubble burst? Dollar rose against the yen from 1995 to 97 Pegged currencies became more over-valued Currency speculation Thailand forced to float bhat More expensive to pay off loans; other countries forced to devalue Fears about banks grew, foreign capital dried up, asset prices fell making loans look worse Financial institutions failed, crisis spread

What were the effects of the crises: On the countries experiencing them? Consumer demand shrinks as wealth shrinks Investments shrink as interest rates rise Credit scarce even for profitable firms Stock prices drop As currencies devalue: exports up and imports and employment down Cost of living up, poverty up

Effects on a country like the United States Reduced exports to affected countries, including agricultural exports Increased import competition Lower prices for imports and consumer goods Stock market instability

Solutions to Short-term financial crises? Restructure banking sectors IMF loans help in some cases Some capital controls on short term flows Foreign aid during crisis In the long run: Move toward totally fixed or totally flexible exchange rates

Conclusion Debt overhang is slowing growth and contributing to poverty in developing countries and also reducing growth in markets for developed countries. Debt solutions for middle and low income countries differ due to differences in private versus public loans

Postcript 2008 U.S. financial crisis Precipitated in part by over-inflated asset (housing) prices and bad loans Bank regulations were too lax, especially with respect to banks reselling to or insuring (swapping) their loans with insurance companies and other financial institutions (which didn’t have adequate collateral). Risks were taken with the (implicit at least) idea that the government would bail them out if too many loans went bad.

Continued Once the loans went bad and the banks and insurance companies started to fail, the government had no alternative but to inject a large amount of capital. Otherwise, no credit would flow and all investments would stop, even very good investments. As it is, the financial crisis led to a recession.

continued In the long run, the government must tighten regulations in the financial sector. The system needs to be changed so this insurance (swap) problem does not occur again in a few years. A lot of other countries in the world were affected by the crisis, both developed and developing