XIX. Developing countries Growth, crisis, defaults

Macro policies for developed (industrialized) countries So far in the course mainly macro economic policies for developed countries Fiscal or monetary in a closed and open economy Reaction to oil shocks in 1970s Anti-inflationary policies in 1980s Monetary policies and inflationary targeting in 1990s

XIX.1 Developing economies Problems of poverty and economic growth Different growth record (Asian success, Latin American hobbling, African disaster) – Conditions for long-term growth – population growth – capital investment Conditions for general productivity improvement: education, transfer of technologies, transparency, efficiency of banking sector and regulation, corporate governance, etc.

First important period: after 1960 Two broad policy approaches Import substituting industrialization, protectionism, capital controls – Most typical example: India, also African countries, extreme case - centrally planned economies Export oriented growth and general development, liberalization, including gradual liberalization of capital controls – Typical example: south-Asian "tigers" - South Korea, Taiwan, Hong-Kong, Singapore Unequivocal success of latter approach

Macro features after the end of B.-W. system Poverty - low savings Low level of development - many (and profitable) investment opportunities However: productive investment! Ensuing danger of debt: if S low and I high, then current account deficit CA = S - I < 0 Different types of risks

Structural changes Liberalization of capital flows After 1973: most developing countries either fixed exchange rate or some type of managed floating – regular interventions, crawling pegs, currency boards, etc. – See Literature Different sets of risks and problems

XIX.2 Balance of payments crisis Efficiency of fixed ExR conditioned by Central Bank´s readiness to defend the fixed rate, using forex reserves It works when markets believe in credibility of this commitment When market do not consider Central Bank's policy as credible - expectation about change in the fixed rate Consequence for asset market equilibrium Usual case: countries with ExR do not poses enough forex reserves - exacerbates the expectations about depreciation

Remember LXII When ExR fixed, but market pressures against the fix, then Central Bank must intervene – Pressure towards appreciation → purchase of foreign assets – Pressure towards depreciation → sale of foreign assets Link between Central Bank intervention and money supply – Purchase of (foreign) assets → increase in money supply – Sale of (foreign) assets → decrease in money supply

Crisis and capital flight Change in expectations - asset market equilibrium requires new level of interest rate Depreciation: need to sell forex reserves to defend fixed rate and unless sterilized (see bellow), decreases money supply and increases the rate Consequence: expected depreciation

E M/P r * +(E e,0 -E)/E r * +(E e,1 -E)/E L(Y,r) Expected returns (domestic, foreign) M 1 /P M 2 /P A B A1A1 B1B1 E0E0 r 1 = r * +(E e,1 -E 0 )/E 0 r0r0 E e,1 > E e,0

BoP crisis mechanics Expected depreciation → need to intervene, sale of forex reserves → increase of money supply, but decrease of reserves Result: sharp fall of reserves and sharp increase of domestic interest rate Loss of reserves ↔ capital flight Danger: self-fulfilling crisis

Sterilization Sale/purchase of foreign assets by Central Bank → decrease/incerase of money supply Sterilization: simultaneous purchase/sale of domestic assets to offset the effect on money supply – Indeed, many Central Banks behave this way Theoretically: sterilized intervention ineffective – so why Central Banks do it? Imperfect asset substitutability – Difference in risk, linked to either domestic or foreign assets

XIX.3 Debts and banking crisis Developing countries – savings lower than investment (see XIX.1 above) : S – I = CA But S (total savings) = S p (private savings) – BD (budget deficit, G-T) Too often: source of insufficient savings – high budget deficits BoP crisis above – particular situation when increasing CA deficit threatens fixed ExR and, consequently, forex reserves Under flexible ExR – the problem more general: how to finance high investment and budget deficits?

Financial flows into developing countries Official lending (IMF, World Banks and other international financial institutions) Bank finance (1970s and 1980s) – loans from commercial banks of developed countries Bond financing – bond issues by developing countries, sold both to state and private entities (till 1914 and after 1990) Foreign direct investment (FDI) – after WWII always important source of financing Portfolio investment by investors from developed countries (privatization)

Denominating currency Problem of debt denominating currency: given the risk of developing countries, lenders insist that debt is denominated in one of reserve currencies – mainly USD, CHF, JPY, GBP, later EUR Danger for developing countries when their currency under pressure – depreciation means that countries’ debt, expressed in domestic currency, increases

Bank runs Developing countries – weak banking sector Improper regulation, weak state guarantees, etc. Bank run – panic among depositors, who „run“ to its bank to withdraw their savings Given the fractional banking system – banks unable to satisfy such a massive attempt to withdraw deposits – Either defaults (bankruptcy) or bank must be bailed out by the state

XIX.4 Sudden stop If any possible trigger of crisis above becomes real, danger of self-fulfilling mechanism Need to pay the debt, i.e. not only interest, but principle as well → large financial outflow from the country In the BoP accounts, corresponding double-entry must be some positive CA item Country must drastically increase savings and run CA surplus: increase private savings (lower consumption), increase government savings (budget surplus), decrease investment and imports, try export everything that „might be exported“ Consequence?: sharp fall in exconomic activity, increase of unemployment, negative growth → “sudden stop”

Different countries in different periods Latin American countries in 1980s and 1990s – Argentina as late as in South Asian countries in Mexico 1987 – 1989 and 1994 again These countries – read Krugman, Obstfeld, Ch. 22 Czech Republic (in a „mini“ scale) in 1997 However: resemblance to recent crisis in some parts of developed countries (see LXXI)

Literature to LXIX Krugman, Obstfeld, Ch. 18, 19 and 22 and readings there