1. XIX. Developing countries Growth, crisis, defaults

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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?

14. 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)

15. 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

16. 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

17. 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”

18. Different countries in different periods Latin American countries in 1980s and 1990s – Argentina as late as in 2000-2001 South Asian countries in 1997-8 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)

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