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Growth, Crisis and Reform

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Title: Growth, Crisis and Reform


1
Chapter 22
  • Growth, Crisis and Reform

2
Introduction
  • The macroeconomic problems of the worlds
    developing countries affect the stability of the
    entire international economy.
  • There has been greater economic dependency
    between developing and industrial countries since
    WWII.
  • 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

3
Income, Wealth, and Growth In the World Economy
  • The Gap Between Rich and Poor
  • The world's economies can be divided into four
    main categories according to their annual
    per-capita income levels
  • Low-income economies
  • Lower middle-income economies
  • Upper middle-income economies
  • High-income economies

4
Income, Wealth, and Growth in the World Economy
Table 22-1 Indicators of Economic Welfare in
Four Groups of Countries, 1999
5
Income, Wealth, and Growth in the World Economy
  • Has the World Income Gap Narrowed Over Time?
  • Industrial countries have shown convergence in
    their per capita incomes.
  • Developing countries have not shown a uniform
    tendency of convergence to the income levels of
    industrial countries.
  • Countries in Africa and Latin America have grown
    at very low rates.
  • East Asian countries have tended to grow at very
    high rates.

6
Output Per Capita in Selected Countries,
1960-1992 (in 1985 U.S. dollars)
7
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

8
Structural Features of Developing Countries
Figure 22-1 Corruption and Per Capita Income
9
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.

10
Developing Country Borrowing and Debt
  • 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.

11
Developing Country Borrowing and Debt
  • History of capital flows to developing countries
  • Early 19th century
  • A number of American states defaulted on European
    loans they had taken out to finance the building
    of canals.
  • Throughout the 19th century
  • Latin American countries ran into repayment
    problems (e.g., the Baring Crisis).
  • 1917
  • 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.

12
Latin America From Crisis to Uneven Reform
  • Inflation and the 1980s Debt Crisis in Latin
    America
  • In the 1970s, as the Bretton Woods system
    collapsed, countries in Latin America entered an
    era of inferior macroeconomic performance.

13
Latin America From Crisis to Uneven Reform
  • Unsuccessful Assaults on Inflation The Tablitas
    of the 1970s
  • 1978
  • Argentina, Chile, and Uruguay all turned to a new
    exchange- rate-based strategy in the hope of
    taming inflation.
  • Tablita
  • It is a preannounced schedule of declining rates
    of domestic currency depreciation against the
    U.S. dollar.
  • It is a type of exchange rate regime known as a
    crawling peg.
  • It declined the rate of currency depreciation
    against the dollar by reducing the rate of
    increase in the prices of internationally
    tradable goods to force overall inflation down.

14
Developing Country Borrowing and Debt
Figure 22-3 Current Account Deficits and Real
Currency Appreciation in Four
Stabilizing Economies, 1976-1997
15
Developing Country Borrowing and Debt
Figure 22-3 Continued
16
Developing Country Borrowing and Debt
Figure 22-3 Continued
17
Developing Country Borrowing and Debt
Figure 22-3 Continued
18
Developing Country Borrowing and Debt
  • 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 Mexicos
    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.

19
Developing Country Borrowing and Debt
  • Reforms, Capital Inflows, and the Return of
    Crisis
  • Argentina
  • 1970s It tried unsuccessfully to stabilize
    inflation through a crawling peg.
  • 1980s It implemented successive inflation
    stabilization plans involving currency reforms,
    price controls, and other measures.
  • 1990s It adopted a currency board (peso-dollar
    peg).
  • 2001-2002 It defaulted on its debts and
    abandoned the peso-dollar peg.

20
Developing Country Borrowing and Debt
  • Brazil
  • 1980s It suffered runaway inflation and
    multiple failed attempts at stabilization
    accompanied by currency reforms.
  • 1990s It introduced a new currency (the real
    pegged to the dollar), defended it with high
    interest rates, and decreased inflation under
    10.
  • Chile
  • 1980s It implemented more reforms and used a
    crawling peg type of exchange rate regime to
    bring inflation down gradually.
  • 1990-1997 It enjoyed an average growth rate of
    more than 8 per year and a 20 inflation
    decrease.

21
Developing Country Borrowing and Debt
  • Mexico
  • 1987 It introduced a broad stabilization and
    reform program and fixed its pesos exchange rate
    against the U.S. dollar.
  • 1989-1991 It moved to a crawling peg and
    crawling band.
  • 1994 It joined the North American Free Trade
    Area and achieved 7 inflation.

22
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

23
East Asia Success and Crisis
Table 22-4 East Asian CA/GDP
24
East Asia Success and Crisis
  • 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

25
East Asia Success and Crisis
  • 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.

26
East Asia Success and Crisis
Table 22-5 Growth and the Current Account,
Five Asian Crisis Countries
27
East Asia Success and Crisis
  • Crises in Other Developing Regions
  • Russias Crisis
  • 1989 It embarked on transitions from centrally
    planned economic allocation to the market.
  • These transitions involved rapid inflation,
    steep output declines, and unemployment.
  • 1997 It managed to stabilize the ruble and
    reduce inflation with the help of IMF credits.
  • 2000 It enjoyed a rapid growth rate.

28
East Asia Success and Crisis
Table 22-6 Real Output Growth and Inflation
Russia and Poland, 1991-2000 (percent per
year)
29
East Asia Success and Crisis
  • Brazils 1999 Crisis
  • It had a public debt problem.
  • It devalued the real by 8 in January 1999 and
    then allowed it to float.
  • The real lost 40 of its value against the
    dollar.
  • It struggled to prevent the real from going into
    a free fall and as a result it entered into a
    recession.
  • The recession was short lived, inflation did not
    take off, and financial-sector collapse was
    avoided.

30
East Asia Success and Crisis
  • Argentinas 2001-2002 crises
  • Its rigid peg of its peso to the dollar proved
    painful as the dollar appreciated in the foreign
    exchange market.
  • 2001 It restricted residents withdrawals from
    banks in order to stem the run on the peso, and
    then it stopped payment on its foreign debts.
  • 2002 It established a dual exchange rate system
    and a single floating-rate system for the peso.

31
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

32
Defining contagion
  • 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.

33
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?

34
Contagion
  • Contagion may and usually does intensify during
    periods of turbulencebut 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.

35
Table on stock co-movement
36
What are the channels of transmission?
  • 1. Trade channels and exchange rate pressures.
  • a. It could be bilateral trade (ex. Chile
    1997-98)
  • b. or competition for trade with a common third
  • partner (ex. East Asias 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 fallsell
    Indonesia).

37
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

38
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39
Possible channels of transmission
40
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 inflowstoo much
    short
  • term debt?
  • 7. Lack of credibilitypoor macroeceonomic track
  • record?

41
Reforming the Worlds Financial Architecture
  • The Asian crisis convinced nearly everyone of an
    urgent need for rethinking international monetary
    relations because of two reasons
  • The fact that the East Asian countries had few
    apparent problems before their crisis struck
  • The apparent strength of contagion through the
    international capital markets

42
Reforming the Worlds Financial Architecture
  • Capital Mobility and the Trilemma of the Exchange
    Rate Regime
  • The macroeconomic policy trilemma for open
    economies
  • Independence in monetary policy
  • Stability in the exchange rate
  • Free movement of capital
  • Only two of the three goals can be reached
    simultaneously.
  • Exchange rate stability is more important for
    developing than developed countries.

43
Reforming the Worlds Financial Architecture
  • Proposals to reform the international
    architecture can be grouped as preventive
    measures or as ex-post measures.
  • Prophylactic Measures
  • Among preventive measures are
  • More transparency
  • Stronger banking systems
  • Enhanced credit lines
  • Increased equity capital inflows relative to debt
    inflows
  • The effectiveness of these measures is
    controversial.

44
Reforming the Worlds Financial Architecture
  • Coping with Crisis
  • The ex-post measures that have been suggested
    include
  • More extensive lending by the IMF
  • Chapter 11 bankruptcy proceeding for the
    orderly resolution of creditor claims on
    developing countries that cannot pay in full.

45
Reforming the Worlds Financial Architecture
  • A Confused Future
  • In the years to come, developing countries will
    experiment with
  • Floating exchange rates
  • Capital controls
  • Currency boards
  • Abolition of national currencies and adoption of
    the dollar or euro for domestic transactions

46
Summary
  • Despite their excellent records of high output
    growth and low inflation, key developing
    countries in East Asia were hit by currency
    depreciation in 1997.
  • Proposals to reform the international
    architecture can be grouped as preventive
    measures or as ex-post measures.
  • The architecture that will ultimately emerge is
    not at all clear.
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