Econ 3551 Chapter 22 Growth, Crisis and Reform

Econ 3552 Introduction 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

Econ 3553 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

Econ 3554 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.

Econ 3555 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

Econ 3556 History of capital flows to developing countries: Early 19 th century  A number of American states defaulted on European loans they had taken out to finance the building of canals. Throughout the 19 th century  Latin American countries ran into repayment problems (e.g., the Baring Crisis)  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

Econ 3557 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

Econ 3558 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

Econ 3559 East Asia: Success and Crisis Table 22-4: East Asian CA/GDP

Econ 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

Econ 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

Econ Tequila crisis ( December ). 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

Econ East Asia: Success and Crisis Table 22-5: Growth and the Current Account, Five Asian Crisis Countries

Econ Crises in Other 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 – It managed to stabilize the ruble and reduce inflation with the help of IMF credits – It enjoyed a rapid growth rate. Success and Crisis

Econ Success and Crisis Table 22-6: Real Output Growth and Inflation: Russia and Poland, (percent per year)

Econ 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

Econ Defining contagion 1. 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.

Econ Defining Contagion After controlling for country specific macroeconomic fundamentals o 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

Econ 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?

Econ 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.”

Econ Table on stock co-movement

Econ What are the channels of transmission? 1. Trade channels and exchange rate pressures. a. It could be bilateral trade (ex. Chile ) 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).

Econ 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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Econ Possible channels of transmission

Econ 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?