1. Developing Countries: Growth, Crisis and Reform

2. The Gap Between rich and Poor 2008 GNP/CapitaLife Expectancy (Years) Low Income$52360 Lower Middle Income$2,07370 Upper Middle Income$7,85275 High income$39,68883 Q: Has the world income gap narrowed over time? A: Starting from 1960 we see very mixed results. Japan, Singapore, Taiwan, Hong Kong, S. Korea – gap has narrowed and converged. For certain African countries the gap has become worse. For some, there has been improvement, but sluggish. Convergence will occur if developing country growth rates exceed those of the industrialised countries, it has occurred for east Asian countries mainly.

3. Structural Features of Developing Countries Extensive direct government control of the economy: – Restrictions on international trade. – Government ownership or control of large industry. – Government control over financial transactions. – High level of government consumption as a share of GNP.

4. Structural Features of Developing Countries (contd…) High inflation history – often due to seignorage (printing money). Weak credit institutions emerge if financial markets are liberalised (bad lending to bad projects). Exchange rates are pegged or managed heavily. Natural resources or agricultural commodities dominate exports. Corruption (which often enhances economic efficency).

5. Developing Country Borrowing and Debt: Financial Inflows to Developing Countries Extensive financial inflows from abroad. Substantial debt to foreigners. Why are there financial inflows to the developing world? Recall: S – I = CA If S < I we have a CA deficit. In developing countries, S is low due to poverty and poor financial institutions. At the same time capital infrastructure is poor which provides opportunity for high investment.

6. So, run a CA deficit and obtain resources from abroad to invest even if domestic saving level is low. But, a CA deficit => borrowing from abroad. This means a country imports more than it exports, with promises to repay in the future (principal + interest). In effect, dividends on shares in firms sold to foreigners. Theoretically, both gain: – Borrowers, because they can build up capital stock despite limited saving. – Lenders, because they gain higher returns on their savings.

7. Alternative Forms of Financial Inflow 1. Bond finance – country issues bonds. 2. Bank finance – decline in importance since the 1990’s. 3. Official lending – WB, ADB, often on “concessional” i.e. low interest rates. 4. FDI – a very important source. 5. Portfolio investment in ownership of firms – reinforced by developing countries’ efforts at privatisation.

8. (1), (2) and (3) are forms of debt finance which have to be repaid regardless of economic circumstances. (4) and (5) are forms of equity finance.

9. A major problem of default is the “curse” of local currency – the problem of “Original Sin” Developing countries are unable to borrow in their own currencies. Developed countries can borrow in their own currencies. Say US$ depreciates. For those US assets denominated in foreign currencies the $ value goes up. However, for US foreign liabilities denominated in US$, the value rises little if at all. The $ depreciation thus results in a net wealth transfer to the US.

10. Read on your own The debt crisis of the 1980’s with special reference to Argentina, Brazil, Chile and Mexico (all Latin American Countries)

11. The East Asian Success Story Beginning in the 1960’s and right up to the Asian financial crisis of 1997, East Asian nations, notably Singapore, South Korea, Taiwan and Hong Kong were held up as models of development. The Asian nations also had certain weaknesses.

12. What was done right? High savings rate (greater capital formation) Strong emphasis on education. Stable macroeconomic environment, low inflation. High trade to GDP ratio.

13. Asian Weaknesses (possibly leading to the financial crisis of 1997) High output explained by increases in input (capital, labour), not by translation into greater productivity. Poor state of banking regulation (cronyism, moral hazard). Weak legal framework for companies facing financial difficulties (inadequate bankruptcy protection, liquidation).

14. Origins of the 1997 financial crisis and spillover to Russia Read on your own.

15. Lessons for developing countries from the 1997 financial crisis. Choice of right exchange rate regime (floating over fixed). Strong Banking system (no poor lending) Sequencing of reform measures has to be “correct” – the ordering of liberalisation measures has to be correct. Domestic supervision and safeguards have to be ensured before the financial A/C is opened up. Avoid “contagion” or the spread of crisis. Even healthy economies far away can suffer from crises of confidence generated elsewhere (domino effect)

16. Reforming the world’s financial architecture “Trilemma” of the exchange rate regime: – Independence in monetary policy. – Stability in the exchange rate. – Free movement of capital. Only two of the above can be established simultaneously. Bhagwati and Rodrick have argued that developing countries should reinstate or maintain capital controls so as to enable the fulfillment of the first two objectives. However, this is a difficult thing to maintain.

17. Prophylactic (preventative) measures to avoid financial crisis Greater transparency (better provision of financial information) Stronger banking systems to ensure less bad debt and lower risk taking. Enhanced credit lines. Sources of credit (eg. IMF, WB, ADB or private banks) which could be drawn upon in the event of a crisis. Mere knowledge of such credit lines would bring stability and, in fact, make them unnecessary. Increased equity capital inflows relative to debt inflows. (Debt leads to default risk)

18. Coping with crisis Role and policies of the IMF. Renegotiate or write-off debt (moral hazard problem).

19. Is Geography Destiny? There is no evidence to support that poorer nations’ incomes are converging to that of richer nations. Capital flows between richer nations far exceed those between rich and poor nations. In fact, since the late 1990’s there has generally been a net inflow of resources from poorer to richer nations (original sin).

20. Geographic Limitations Diamond posits that geographic factors inhibit the growth of certain countries. Bad climate, lack of animal domestication, prevalence of disease, land-locked geography (preventing access to sea trade-routes) all contribute to under-development and may explain why it was Europe which conquered, not the other way round.

21. Institutional Limitations Acemoglu et al. argue that weak institutions inhibit growth. Corruption, a weak judiciary and unstable politics prevent people from enjoying the fruits of their efforts and make it unattractive for investment, internal and external. Geography often combines with institutions. Places where, due to disease, Europeans could not permanently settle ended up having weak institutions. In parts of Africa and Asia the local environment meant that Europeans could not settle. So they set up mechanisms to plunder wealth quickly and left. No lasting institutions remained.