Chapter 22 Developing Countries: Growth, Crisis, and Reform

2  Income, Wealth, and Growth in the World Economy  Developing Country Borrowing and Debt  Latin America: From Crisis to Uneven Reform  East Asia: Success and Crisis  Lessons of Developing Country Crises  Reforming the World’s Financial “Architecture” Kernel of the Chapter

3 Introduction  The macroeconomic problems of the world’s developing countries affect the stability of the entire international economy.  This chapter examines the macroeconomic problems of developing countries and the repercussions of those problems on the developed countries.

4  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 Income, Wealth, and Growth In the World Economy

5 Income, Wealth, and Growth in the World Economy Table 22-1: Indicators of Economic Welfare in Four Groups of Countries, 1999

6  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. Income, Wealth, and Growth in the World Economy

7 Table 22-2: Output Per Capita in Selected Countries, (in 1985 U.S. dollars)

8 Structural Features of Developing Countries  Most developing countries have at least some of the following features: Direct government control of the economy History of high inflation reflecting government attempts to extract seigniorage Weak credit institutions and undeveloped capital markets Pegged exchanged rates and exchange or capital controls Heavy reliance on primary commodity exports High corruption levels

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

10 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.

11 Table 22-3: Current Account Balances of Major Oil Exporters, Other Developing Countries, and Industrial Countries, (billions of dollars) Developing Country Borrowing and Debt

12 Table 22-3: Continued Developing Country Borrowing and Debt

13  The Problem of Default Borrowing by developing countries has sometimes led to default crises. Developing Country Borrowing and Debt History of capital flows to developing countries: –Early 19 th century –Throughout the 19 th century –1917 –Great Depression (1930s)

14  Alternative Forms of Capital Inflow Five major channels : –Bond finance –Bank finance –Official lending –Direct foreign investment –Portfolio investment in ownership of firms –privatization.efforts Developing Country Borrowing and Debt

15 The five types of finance can be classified into two categories: –Debt finance –Equity finance Developing Country Borrowing and Debt  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.

16 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 –a type of exchange rate regime known as a crawling peg. –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. Latin America: From Crisis to Uneven Reform

17 Figure 22-3: Current Account Deficits and Real Currency Appreciation in Four Stabilizing Economies, Developing Country Borrowing and Debt

18 Figure 22-3: Continued Developing Country Borrowing and Debt

19 Developing Country Borrowing and Debt Figure 22-3: Continued

20 Developing Country Borrowing and Debt Figure 22-3: Continued

21 The Debt Crisis of the 1980s –The great recession of the early 1980s –The shift to contractionary policy by the U.S. led to: –The fall in industrial countries' aggregate demand –Rise in the interest burden debtor countries had to pay –Sharp appreciation of the dollar –Collapse in the primary commodity prices –In 1982 Mexico’s central bank stoped to pay its foreign debt. –By the end of 1986 more than 40 countries had encountered several external financial problems. Developing Country Borrowing and Debt

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

23 Brazil –1980s –runaway inflation and failed attempts at stabilization accompanied by currency reforms. –1990s –a new currency (the real pegged to the dollar), high interest rates, and decreased inflation under 10%. Chile –1980s –more reforms and a crawling peg to bring inflation down gradually. – –an average growth rate of more than 8% per year and a 20% inflation decrease. Developing Country Borrowing and Debt

24 Mexico –1987 –a broad stabilization and reform program and fixed its peso’s exchange rate against U.S. dollar. – –a crawling peg and crawling band. –1994 – It joined the NA FT A and achieved 7% inflation. Developing Country Borrowing and Debt

25 East Asia: Success and Crisis  The East Asian Economic Miracle Until 1997 having very high growth rates. the ingredients for 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

26 East Asia: Success and Crisis Table 22-4: East Asian CA/GDP

27  Asian Weaknesses –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 East Asia: Success and Crisis

28  The Asian Financial Crisis Devaluation of the Thai baht. on July 2, 1997 Speculation against the currencies of: Malaysia, Indonesia, and South Korea. –All except Malaysia turned to the IMF for HELP. “V-shaped”: ’S growth. East Asia: Success and Crisis

29 East Asia: Success and Crisis Table 22-5: Growth and the Current Account, Five Asian Crisis Countries

30  Crises in Other Developing Regions Russia’s Crisis –1989 –transitions from centrally planned economic allocation to the market. –rapid inflation, steep output declines, and unemployment. –1997 –managed to stabilize the ruble and reduce inflation with the help of IMF credits. –2000 – It enjoyed a rapid growth rate. East Asia: Success and Crisis

31 East Asia: Success and Crisis Table 22-6: Real Output Growth and Inflation: Russia and Poland, (percent per year)

32 Brazil’s 1999 Crisis –a public debt problem. –devalued the real by 8% in January 1999 and then allowed it to float. –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. East Asia: Success and Crisis

33 Argentina’s crises –Its rigid peg of its peso to the dollar. –2001 –restricted residents’ withdrawals from banks in order to stem the run on the peso, and stopped payment on its foreign debts. –2002 – It established a dual exchange rate system and a single floating-rate system for the peso. East Asia: Success and Crisis

34 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

35 Reforming the World’s 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

36  Capital Mobility and the Trilemma of the Exchange Rate Regime The macroeconomic policy trilemma for open economies: –IMPOSSIBLE TRIANGle Exchange rate stability is more important for developing than developed countries. Reforming the World’s Financial “Architecture”

37 Reforming the World’s Financial “Architecture” Figure 22-4: The Policy Trilemma for Open Economies Currency board Capital controls Floating exchange rate Exchange rate stability Freedom of capital movement Monetary policy autonomy

38  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. Reforming the World’s Financial “Architecture”

39  Coping with Crisis The ex-post measures 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. Reforming the World’s Financial “Architecture”

40  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 Reforming the World’s Financial “Architecture”