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Chapter 16 The External Debt and Financial Crises

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1 Chapter 16 The External Debt and Financial Crises
CHAPTER 16 ©E.Wayne Nafziger Development Economics

2 CHAPTER 16 ©E.Wayne Nafziger Development Economics
External Debt Crisis External debt is owed to nonresident government, businesses, and institutions and repayable in foreign currency. A debt crisis reduces growth in economic welfare. Financial and currency crises in Thailand and Indonesia, , and Argentina, , reduced output more than the Great Depression. CHAPTER 16 ©E.Wayne Nafziger Development Economics

3 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Deficit & loan decline LDCs’ persistent deficit on balance on goods, services, and income through 1980s & 1990s, and decline in loans at bankers’ standards in the 1990s, contributed to continuing LDC crisis. CHAPTER 16 ©E.Wayne Nafziger Development Economics

4 Dual nature of debt & financial crises
For Latin America & middle-income borrowers: debt owed to commercial lenders. Sub-Saharan Africa: debt owed primarily to bilateral governments and multilateral lenders. CHAPTER 16 ©E.Wayne Nafziger Development Economics

5 Capital mobility & financial crises
International capital mobility rose in the last quarter of the 20th century Global foreign exchange transactions $15 billion daily in 1973, $60 billion (1983), $900 billion (1992), and $2 trillion (2000), far in excess of world central bank reserves ($2 billion). Foreign exchange to trade flows worldwide were 9:1 (1973), 12:1 (1983), 90:1 (1992), and 900:1 (2000). CHAPTER 16 ©E.Wayne Nafziger Development Economics

6 Capital mobility & financial crises
Cross-border capital movements benefited long-term growth of recipients East Asia, Latin America, and Russia. However, because of potential reverse outflows, especially of portfolio and mutual funds, capital movements increased their vulnerability to crises. Not surprisingly, financial crises occurred in Mexico (1994), Southeast and East Asia ( ), and Argentina ( ) following substantial capital-account liberalization & increases in capital flows. CHAPTER 16 ©E.Wayne Nafziger Development Economics

7 Capital mobility & financial crises
Ranciere, Tornell, and Westerman (2003) show that among 52 LDCs, capital-flow liberalizers grew by 2 percentage points faster than nonliberalizers, with bank credit growth responsible for half the advantage. Despite the crisis, Thailand’s growth in gross domestic income per person was 4.5 percent compared to 3.3 percent yearly, , for mostly nonliberalizing India, a cumulative difference of more than 50 percent. CHAPTER 16 ©E.Wayne Nafziger Development Economics

8 Definitions of debt service
Debt service: the interest and principal payments due in a given year on long-term debt. Debt-service ratio: the interest and principal payments/exports of goods and services (in a given year on long-term debt). CHAPTER 16 ©E.Wayne Nafziger Development Economics

9 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Origins of debt crises Chronic international balance on goods, services, & income deficits 1970s through most of 1990s. Commercial lending increased relative to aid. LDCs borrowed money cheaply in the 1970s that rolled over when money was tight in the early 1980s. CHAPTER 16 ©E.Wayne Nafziger Development Economics

10 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Origins of debt crises Inefficiency & poor national economic management in some African & Latin American countries. Widespread adjustment among primary product producers resulted in price collapse. Floating exchange rate system increased external shocks for LDCs. CHAPTER 16 ©E.Wayne Nafziger Development Economics

11 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Origins of debt crises Volatility in the value of leading reserve currencies. LDC governments compelled to guarantee private debt. Overvalued domestic currencies & restrictions on international trade hurt current account balance Substantial capital flight from foreign aid, loans, and investment. CHAPTER 16 ©E.Wayne Nafziger Development Economics

12 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Capital flight Definition: resident capital outflow (cannot measure readily with definitions characterizing flight as illegal or abnormal). Propensity to flee from external borrowing as high as 30-50% or more in many LDCs. CHAPTER 16 ©E.Wayne Nafziger Development Economics

13 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Capital flight Results from differences in perceived risk-adjusted returns in source & haven countries. Source countries: slow growth, overvalued currencies, inflation, confiscatory taxation, limitations on convertibility, poor investment climate, & political instability. Haven countries: US’s abandonment of income taxation on nonresident bank-deposit interest & much other investment income. CHAPTER 16 ©E.Wayne Nafziger Development Economics

14 Zairian (Congo – Kinshasa) pathology
Congo – Brazzaville diamond exporter in 1970s & early 1980s from diamonds smuggled from Congo – Kinshasa. President Mobutu’s stashing of funds in Swiss banks & Western real estate was enough to pay Zaire’s debt. Other predatory rulers from failed states had similar problems. Acquired Investments Deposited in Switzerland is Africa’s second AID epidemic (Africa Research Bulletin 1991). CHAPTER 16 ©E.Wayne Nafziger Development Economics

15 Capital flight may be caboose not locomotive of crisis
Capital flight symptomatic of financial repression & economic underdevelopment not cause of it (de Vries 1987). Limited policy prescriptions in weak states. In desperate situation, exchange controls may be essential. CHAPTER 16 ©E.Wayne Nafziger Development Economics

16 CHAPTER 16 ©E.Wayne Nafziger Development Economics
US Banking Crisis Early 1980s: US feared complete writeoff of LDC debts would wipe out many major US commercial banks, with substantial exposure to LDC debt. Early 1990s: debt repudiations no longer threatened money-center banks of New York City, but little changed in Africa & Latin America. CHAPTER 16 ©E.Wayne Nafziger Development Economics

17 CHAPTER 16 ©E.Wayne Nafziger Development Economics
US exposure reduced US reduced exposure to nonperforming LDC debt by: reducing commercial bank lending. some loan writeoffs & write-downs. Japan & World Bank helped with debt write-downs. CHAPTER 16 ©E.Wayne Nafziger Development Economics

18 Spreads & risk premiums
Commercial banks charge risk premium for LDC borrowers, a premium that rises with major financial crises. Premium may vary from interest rates 1-2 percentage points in excess of London Interbank Offered Rate (LIBOR), a virtually riskless interest rate to 15 percentage points. CHAPTER 16 ©E.Wayne Nafziger Development Economics

19 CHAPTER 16 ©E.Wayne Nafziger Development Economics

20 Crisis from LDC perspective
Table 16-1 indicates LDC debt increased for more than $1 trillion in late 1980s to $2.3 trillion in 2001. Severely indebted countries of the 1980s, many from Africa & Latin America, grew slower than countries of any debt classification. CHAPTER 16 ©E.Wayne Nafziger Development Economics

21 CHAPTER 16 ©E.Wayne Nafziger Development Economics

22 Sub-Saharan Africa in crisis
Debt overhang contributed to fall in health spending, child nutrition, and infant survival among poor in early 1980s. decline in real wages, employment rate, & health & educational expenditure shares in late 1980s. CHAPTER 16 ©E.Wayne Nafziger Development Economics

23 Sub-Saharan Africa in crisis
Tanzania’s President Julius Nyerere (1985): “Must we starve our children to pay our debt.” From 1980 to 2000, Africa’s scarce foreign exchange went to debt service rather than socio-economic development, thus increasing child malnutrition and reducing life expectancy. CHAPTER 16 ©E.Wayne Nafziger Development Economics

24 Latin America countries in 1980s
Some experienced deterioration in social indicators during the 1980s. Argentine President Raul Alfonsin (1987): the West must recognize how “current economic conditions impede our development and condemn us to backwardness. We cannot accept that the south pay for the disequilibrium of the north.” CHAPTER 16 ©E.Wayne Nafziger Development Economics

25 Location of financial crises
Mexico (1994), Thailand, Indonesia & South Korea (1997), Brazil (1998), Russia (1998), Turkey (2000), Argentina (2001). All except Brazil & Russia reduced GDP the year after the crisis. Argentina, Indonesia, & Thailand had a fall in GDP of more than 10%. Others reduced output (Figure 17-2). Indonesia’s poverty rate increased from 16% (1996) to 27% (1999) (World Bank 2003). CHAPTER 16 ©E.Wayne Nafziger Development Economics

26 CHAPTER 16 ©E.Wayne Nafziger Development Economics

27 IMF’s Managing Director Camdesus
“Adjustment does not have to lower basic human standards Unfortunately, poverty groups” [not] represented in government.” (1989) In practice, Camdesus’s statement exaggerates “the extent to which the Fund has moved from [its] traditional brief.” (Mosley, Harrigan, & Toye 1991). CHAPTER 16 ©E.Wayne Nafziger Development Economics

28 In poorest African countries
Majority of population lives close to subsistence ($1/day poverty). Welfare payments to bring the population above the poverty line would undermine work incentives and prohibitively expensive. Need something like World Bank’s Social Dimensions of Adjustment Projects (SDA). Internal politics results in privileged interest groups but not the poor receiving compensation for adjustment. CHAPTER 16 ©E.Wayne Nafziger Development Economics

29 Debt service ratios (DSRs)
Severely indebted middle-income countries’ debt service ratio, , was 81% in Brazil, 67% in Argentina, & 50% in Lebanon, not sustainable. Argentina defaulted & rescheduled debt Sub-Sahara’s actual DSR 34%, scheduled DSR 66% (1990): difference reflects substantial default & debt rescheduling and forgiveness. CHAPTER 16 ©E.Wayne Nafziger Development Economics

30 CHAPTER 16 ©E.Wayne Nafziger Development Economics

31 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Net transfers Net international resource flows (investment, loans, and grants) minus net international interest payments and profit remittances (p. 564). World Bank positive net transfers to sub-Saharan Africa ( ), although not confirmed as a policy, perhaps for fear of establishing a precedent. CHAPTER 16 ©E.Wayne Nafziger Development Economics

32 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Major LDC Debtors Leaders are not necessarily those with worst debt crisis: In 2001, Brazil ($226 billion), China ($170 billion), Mexico ($158 billion), Russia ($153 billion), Argentina ($137 billion), Indonesia ($136 billion), Turkey ($115 billion), & India ($97 billion). Only Indonesia, Argentina, Brazil, & Lebanon are classified as severely indebted middle-income countries. Congo (DRC), Ivory Coast, Ethiopia, Nigeria, Sierra Leone (not beneficiaries of Jubilee 2000 write-downs), have debt burdens more difficult to bear than most in Table 16-3. CHAPTER 16 ©E.Wayne Nafziger Development Economics

33 CHAPTER 16 ©E.Wayne Nafziger Development Economics

34 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Major debtors Between 1980-January 2002, 78 LDCs renegotiated foreign debts through multilateral agreements under Paris Club (for official creditor groups) and London Club (for commercial banks. Not much correlation between renegotiations & largest debtors in Table 16-3. South Korea, one of largest LDC debtors (until graduated to high-income economy in 1994) because of high credit rating. Still Korea suffered from contagion of 1997 Asian crisis. CHAPTER 16 ©E.Wayne Nafziger Development Economics

35 Financial & Currency Crises
Problems: despite benefits of open capital markets, financial markets often perform poorly when immediately liberalizing, increasing percentage of nonperforming loans, encountering bad credit risks disproportionately eager to take out loans, lacking information on assessing expanded lending, borrowers’ collateral falls from currency devaluation, & interest rates increase sharply. Asymmetries in information (present in 1990s’ crises) between lender & borrower. CHAPTER 16 ©E.Wayne Nafziger Development Economics

36 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Jong-Il You (2002) The IMF has contradictory signals, supporting “ capital account liberalization [that] expos[es] a country to the ebbs and flows of capital that are regulated by the judgement and opinions of international bankers and fund managers [T]he patent failure of the Fund’s initial rescue operations in the wake of the Asian financial crisis underscored the fact that it was ill-equipped to deal with this new form of crisis.” CHAPTER 16 ©E.Wayne Nafziger Development Economics

37 1990s’ Mexican & Asian crises
Large fiscal deficits, inflation, & money supply not factors in crises. Capital inflows/GDP, bank nonperforming loan ratios, & current account deficits were high; credit growth was fast; (and except for Korea) the domestic currency (set at a constant nominal rate for several years) had experienced a real appreciation. CHAPTER 16 ©E.Wayne Nafziger Development Economics

38 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Krugman & Bhagwati Supported capital controls for Malaysia in 1998 (undertaken soon after their announcement of support). Malaysia’s recovery was faster. Within a year, Malaysia restored capital convertibility. However, capital controls “provided a screen behind which [political cronies and] favored firms could be supported” (Johnson & Mitton). CHAPTER 16 ©E.Wayne Nafziger Development Economics

39 World Bank & IMF adjustment
World Bank’s mandate is development lending to LDCs. IMF lent resources to help DCs & LDCs cope with balance of payments crises. World Bank sectoral adjustment loans (SECALs) emphasized reforms in trade, agriculture, industry, public enterprise, finance, energy, education, & other sectors. CHAPTER 16 ©E.Wayne Nafziger Development Economics

40 IMF structural adjustment loans
Structural adjustment loans: emphasis on macroeconomic stabilization. Conditionality, a quid pro quo for borrowing, includes the borrower’s adopting adjustment policies to attain a viable balance of payments. World Bank and other lenders/donors relied on IMF “seal of approval” for aid, loans, and investment. CHAPTER 16 ©E.Wayne Nafziger Development Economics

41 Fundamentalists vs. Columbia school
What are the origins of the Asian crisis, ? Fundamentalists such as Goldstein (1998) emphasize financial sector weakness (including inadequate supervision); high bad-debt ratios, large current-account deficits, fixed exchange rates, overvalued currencies, contagion of financial disturbances causing portfolio investors to reassess Asian inventories, increased risky behavior (failure to hedge), and moral hazard from previous international bailouts. CHAPTER 16 ©E.Wayne Nafziger Development Economics

42 Columbia School (Stiglitz-Sachs)
Agree with much of fundamentalists’ analysis on causes but differ on prescription. Fundamentalists want IMF to lend only if undertake fundamental structural reforms in banking. Stiglitz thinks it’s unrealistic for IMF to loan short term, expecting reforms that can only be attained in the middle- to long-run. Legal & institutional preconditions for effective banking supervision, licensing, & regulation & operational independence takes time & resources. CHAPTER 16 ©E.Wayne Nafziger Development Economics

43 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Why contagion? Fundamentalists believe that herd behavior of Western portfolio investors transmitted crisis from one Asian country to another then to Russia & Latin America. Stiglitz emphasizes Keynesian explanation for contagion, that “belt tightening” imposed by IMF reduced incomes & imports that successively weakened neighbors. CHAPTER 16 ©E.Wayne Nafziger Development Economics

44 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Jong-Il You (2002) Having helped generate the financial crises by urging capital account liberalization in developing and transition economies, the Fund took on the role of firefighters, enlisting the [World] Bank for a supporting role. The quick recoveries of Mexico and Asia are [not] vindication [but] may simply have been a consequence of the fact that the crises were mainly panic-driven. In fact, the [IMF] was ill-equipped to deal with this new form of crisis. CHAPTER 16 ©E.Wayne Nafziger Development Economics

45 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Stiglitz’s view Initially IMF was to undertake global collective action to ameliorate market failure. Major task to support economic stability by spurring growth and reducing unemployment. Stiglitz opposes draconian monetary & fiscal policies IMF imposes as condition for LDC borrowing. This is against IMF and World Bank’s initial emphasis on expanding employment and combating market failure. CHAPTER 16 ©E.Wayne Nafziger Development Economics

46 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Stiglitz Regrets billions of dollars trying to maintain exchange rates of Brazil & Russia. Foreigners & rich gain at expense of population at large in debtor country. IMF more concerned about IMF’s, US Treasury’s, & world financial community’s views than Asian workers & taxpayers. CHAPTER 16 ©E.Wayne Nafziger Development Economics

47 Changing international financial architecture
Mistry (1999): rails against IMF monopoly on crisis management. Need regional arrangements in Asia as in rich countries & Europe. Why did the US oppose an Asian regional monetary fund? CHAPTER 16 ©E.Wayne Nafziger Development Economics

48 International architecture
Nayyar (2002): need institution for global macroeconomic management. Keynes (1944) envisioned International Clearing Union (became IMF) as clearing house for member debts. Keynes: IMF should put burden on surplus not deficit economies. Stiglitz: Keynes must be turning over in his grave. CHAPTER 16 ©E.Wayne Nafziger Development Economics

49 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Meltzer Commission (2000) IMF, World Bank, & regional development banks should write off debts of highly indebted poor countries (HIPCs). Access to IMF credit automatic & immediate for countries meeting a priori requirements. Bank & development banks should concentrate on poverty reduction. IMF should loan for short-term liquidity not for poverty reduction, aid, or structural reform, for which it is ill suited. Bush administration embraced but Europeans told Bush that this would erode World Bank resources. CHAPTER 16 ©E.Wayne Nafziger Development Economics

50 CHAPTER 16 ©E.Wayne Nafziger Development Economics
IMF failed proposal Stay of payments during crisis (Fischer 1999) IMF’s Sovereign Debt Restructuring Mechanism Give debtors legal protection (payment standstill). Creditor assurances to negotiate in good faith & support restored growth. Fresh private lending not restructured. Verify claims, oversee voting, & adjudicate disputes. Collective action clauses (CAC) into new bonds & loans, so single creditor could not undermine debt restructuring process. CHAPTER 16 ©E.Wayne Nafziger Development Economics

51 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Resolving debt crisis Debt cancellation. Concerted action. Baker Plan 1985 – new moneys. Brady Plan 1989 – debt reduction & restructuring, with debt buybacks. Debt exchanges, debt-equity swaps, debt buybacks, debt-for-nature swaps, debt-for-development swaps, other debt exchanges. Rescheduling debt. CHAPTER 16 ©E.Wayne Nafziger Development Economics

52 Rescheduling & writing down debt of HIPCs
Jubilee 2000: massive writing down of debt. CHAPTER 16 ©E.Wayne Nafziger Development Economics

53 CHAPTER 16 ©E.Wayne Nafziger Development Economics
Policy Cartel World Bank, DC governments or commercial banks require IMF “seal of approval” for macroeconomic stabilization program before lending (Mosley, Harrigan, & Toye 1991). CHAPTER 16 ©E.Wayne Nafziger Development Economics


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