Financial barriers

Three types of barriers 1. High indebtedness of developing countries 2. Capital flight 3. Non-convertible currencies

LDCs indebtedness Indebtedness is a country’s level of external (or foreign) debt. It equals the total amount of debt (public and private) incurred by borrowing from foreign creditors. Indebtedness is a country’s level of external (or foreign) debt. It equals the total amount of debt (public and private) incurred by borrowing from foreign creditors. Borrowing from foreign sources is a credit in the financial account of the BOP and helps countries pay for deficits in the current account. Borrowing from foreign sources is a credit in the financial account of the BOP and helps countries pay for deficits in the current account. But it has costs: ‘debt servicing’ (payment of principal + interest). But it has costs: ‘debt servicing’ (payment of principal + interest).

Consequences of high indebtedness Consequences of high indebtedness 1. Debt trap. If X revenues not enough for debt servicing → need to borrow more → larger debt service payments → debt becomes unsustainable. 2. BOP problems due to the high levels of debt. 3. Lower private investment if fears that a government may be unable to service debts. Mainly short term investments. 4. Lower public investment. Less resources for poverty alleviation and social services.

5. Diversion of X revenues away from needed imports and towards debt servicing. 6. 3, 4 and 5 → Lower economic growth

Consequences of policies intended to address high indebtedness in LDCs. In the 80s, IMF and World Bank intervened to avoid that some LDCs defaulted on their loans. As a consequence: Consequences of policies intended to address high indebtedness in LDCs. In the 80s, IMF and World Bank intervened to avoid that some LDCs defaulted on their loans. As a consequence: Debt burden has decreased Debt burden has decreased But in some cases at the expense of economic growth. But in some cases at the expense of economic growth. 1. Policies imposed by IMF Mainly loan restructuring (ie, granting of new loans with longer time period and lower i ). Requirement: meet policy requirements imposed by the IMF. Mainly loan restructuring (ie, granting of new loans with longer time period and lower i ). Requirement: meet policy requirements imposed by the IMF.

These were tight fiscal and monetary policies intended to: These were tight fiscal and monetary policies intended to: o ↓Gov spending (by reducing provision of merit goods) and ↑ gov revenues (by increasing prices of services provided by public firms, imposition of fees for education and health services) o ↑ Interest rates o ↓ AD and ↓ Demand for M This led to lower econ growth, ↑ UE and ↑ poverty.

2. Low success of HIPC initiative. In the 90s, WB and IMF begun this initiative to provide debt relief to a number of highly indebted poor countries by cancelling a portion of their debts. Conditions: Follow certain WB, IMF policies such as ↓ G and liberalize markets. Follow certain WB, IMF policies such as ↓ G and liberalize markets. Pursue a poverty reduction strategy. Pursue a poverty reduction strategy. Criticisms: Insufficient level of debt reduction, takes effect too slowly, severity of some measures, many highly indebted countries were not included in the initiative.

3. Increased foreign control of domestic assets due to debt-for-equity swaps. Debt for equity swaps: a highly indebted country exchanges a portion of its debt for equity, which is taken up by foreign corporations. The foreign corporation takes responsibility for a portion of a government’s debt and in exchange the government gives it ownership of some of its assets. Much of Latin American privatization occurred this way. Problem: assests are frequently acquired at a large discount, so control of assets is lost at a price far lower than the market price.

Capital flight Definition: Large scale transfer of privately owned financial capital to another country. Definition: Large scale transfer of privately owned financial capital to another country. It results from high uncertainty and risk of holding domestic assets due to: It results from high uncertainty and risk of holding domestic assets due to: Risk of confiscation Risk of confiscation Sudden ↑ taxation Sudden ↑ taxation Political instability Political instability Anything leading to loss of value of the domestic currency. Anything leading to loss of value of the domestic currency.

Problems: Problems: 1. It involves a loss of financial capital that could have been invested domestically. 2. Sale of domestic currency → downward pressure on its value, forcing gov to devalue or allowing depreciation. 3. Worsens external debt problem, as it involves use of scarce foreign exchange → ↑ need for external debt borrowing. In Mexico in 94-95, political instability and lack of confidence in the economy led to massive sales of pesos, a drop in foreign reserves, massive capital flight and devaluation of the peso.

Non-convertible currencies Fully convertible currency: can be freely exchanged for other foreign currencies. Fully convertible currency: can be freely exchanged for other foreign currencies. Fully non-convertible currency: cannot be exchanged for other currencies because of government restrictions. Fully non-convertible currency: cannot be exchanged for other currencies because of government restrictions. Non-convertible currency: convertible only for specified foreign transactions. It may apply to current acount and financial account transactions. Non-convertible currency: convertible only for specified foreign transactions. It may apply to current acount and financial account transactions. Many LDCs still maintain non-convertibility for their financial accounts. Many LDCs still maintain non-convertibility for their financial accounts.

1. Non-convertibility for current account transactions (mainly foreign trade). Conversion of currencies is subject to gov restrictions. For example, only for specific imports and exports consistent with gov objectives. Today most countries have convertible currencies for CA transactions. Today most countries have convertible currencies for CA transactions. Benefits: based on the principle that Int’al trade should be conducted in the context of competitive mkts. Benefits: based on the principle that Int’al trade should be conducted in the context of competitive mkts.

2. Non-convertibility for financial account (FA) transactions. Implies gov control over what flows are permissible. Exceptions for: debt service payments, funds to be used in inward FDI, inward flows due to borrowing, financial investment by foreigners. Benefits of non-convertibility for FA: a) Capital flight can be avoided, as financial capital cannot leave the country if the domestic currency cannot be converted into foreign currencies. b) Currency speculation is also avoided.

c) Ability to conduct monetary policy independently of exchange rate considerations. In case of a recession, for example, the interest rate can be lowered without risk of a depreciation. Conditions to be met before full convertibility. 1) Stable political system 2) Sound fiscal and monetary policies that encourage confidence in domestic assets and currency. 3) Sound macro policies that work to avoid wide exchange rate fluctuations and large BOP deficits. 4) Strong financial institutions that operate under gov regulation to avoid excessive risks. 5) Mkt orientation, with well-functioning price system that facilitates more efficient allocation of resources and financial capital.

Benefits of full convertibility for FA: Benefits of full convertibility for FA: 1. Access to foreign capital markets (ability to diversify financial investments). 2. Access to more varied and cheaper sources of finance. 3. Encourages FDI. 4. Permits inflows of financial capital, as foreigners know they can sell their assets if they wish. 5. ↑ competition among financial institutions → ↑ efficiency + ↓ costs.

6. Prevents black market for foreign exchange 7. 1 to 6 contribute to greater economic growth. 8. Facilitates efficient global allocation of savings.

Currency convertibility and financial crises. Currency convertibility and financial crises. Several East Asian countries experienced a severe financial and economic crisis in the late 90s. These economies had extended convertibility of their currencies to the FA (under pressure from the IMF). In 1997, recession + declining confidence in the economy triggered attacks on their currencies, resulting in massive capital flight and downward pressures on the value of their currencies. IMF stepped in with loans and imposed tight monetary policy in order to curtail capital flight and help support the currencies. However, confidence was low and downward pressure on curr continued. High i created negative growth, higher UE and poverty. According to Stiglitz, FA liberalization ‘...was the single most important factor leading to the crisis’.