EC336 Economic Development in a Global Perspective

1. EC336Economic Development in a Global Perspective Abhishek chakravarty 2013-14 Lecture 5

2. Lecture Outline • We will examine how major debt crises emerged during the 1980s and more recently in 2008. • We will look at IMF stabilisation policies and attempts at debt relief in this context. • The material is all from Todaro and Smith, chapter 13. • The next lecture will deal exclusively with aid flows as a source of capital.

3. The Balance of Payments Account • A country’s balance of payments is an accounting breakdown of its financial transactions with the rest of the world. • It is usually reported in two parts. Current account inflows are export revenues net of import expenditure, net investment income , and net remittances and transfers, minus debt service payments. • Capital account inflows are private foreign direct investment and foreign loans net of amortisation, minus foreign assets acquired abroad and resident capital outflows. • Whenever current and capital account disbursements exceed or are less than receipts, the difference is recorded as a decrease/increase in the cash account or international reserve account.

4. The Balance of Payments Account

5. The Balance of Payments Account • Countries accumulate reserves in three forms when receipts exceed disbursements: • Foreign hard currency, usually US dollars or Euros. • Gold, either bought from domestically mined stocks in the private market or imported. • IMF reserves, as the IMF acts as a reserve bank for many nations’ central banks. • When disbursements exceed receipts, or there is a balance of payments deficit, these reserves have to be run down or other strategies to reduce debts have to be adopted. • Some of these strategies include adopting import substitution and export promotion, which we have seen already. Or IMF structural adjustment loans can be taken on.

6. Emergence of the 1980s Debt Crisis • Accumulation of external debt is often an essential part of the initial stages of development for capital-scarce developing countries, but poor management of debt or unforeseen changes in economic circumstances can create unmanageable debt service obligations. Net capital inflow, FN, is Basic transfer, BT, is Where d is percent increase in total debt Dis total debt ris the average interest rate

7. Emergence of the 1980s Debt Crisis • When D is small initially, d is large. Also when the debt is incurred from official sources such as the World Bank at low long term interest rates, or at concessional terms, the servicing cost is low due to smaller r. • The basic transfer becomes negative when D becomes so large that d becomes small and inadequate to meet servicing obligations, and r increases due to change in composition of loans towards debt from private non-official sources at variable rates and non-concessional terms, combined with monetary policy changes in the home countries of foreign lender banks. • D can become large in response to declining terms of trade for exports, price shocks to essential imports, or sudden changes to currencies such as the dollar in which most loans are denominated.

8. Emergence of the 1980s Debt Crisis • In 1974-79 there was a large increase in international lending to developing countries, fueled by high oil prices that increased OPEC oil export earnings. The OPEC countries in turn deposited these export earnings in developed country commercial banks, who needed to invest this money in high return areas. • Countries such as Argentina, Mexico, and Brazil were importing capital goods and oil heavily at this time to produce for export markets, and were in need of credit to sustain higher growth rates in the face of global economic slowdown brought on by higher oil prices. • Low growth in developed countries hence made the Latin American countries as well as other developing countries an attractive alternative for commercial banks to lend to, and they did so without conditionalities unlike official lenders (e.g. IMF) which these countries also found beneficial.

9. The Mechanics of Petrodollar Recycling

10. Emergence of the 1980s Debt Crisis • The level of debt to developing countries more than doubled as a result, from $180 billion in 1975 to $406 billion in 1979. The proportion of this debt on shorter terms and at variable interest rates also increased from 40% in 1971 to 77% in 1979, placing developing countries at a much riskier position in the composition of their debt. • Debt servicing payments from these countries also tripled as a result from $25 billion in1975 to $75 billion in 1979, but economic conditions improved in the latter half of the 1970s making these payments manageable. Inflation reduced real oil prices and real interest rates, and increased nominal export earnings. • As a result developing countries also averaged a high rate of growth of 5.2% during 1973-79 via this large-scale international borrowing.

11. Emergence of the 1980s Debt Crisis • A second oil price shock in 1979 created several new difficulties. The oil price increase drove up oil import bills and made industrial good imports more expensive. There was also an accompanying decline in export earnings due to slowed growth in developed countries and a 20% decline in the terms of trade for primary product exports. • Interest rates increased substantially due to restrictive monetary policy in developed countries aimed at reducing inflation. These interest rate hikes were passed on by developed country commercial banks to developing countries in their debt servicing charges, which rose sharply due to the short-term and variable rate nature of the loans. • Finally there was also a tremendous increase in private capital flight from developing to developed countries, equaling about 50% of total developing country debt over 1976-1985. This reduced the amount of domestic funds available to pay back foreign loans.

12. Current Account Balances and Capital Account Net financial Transfers of Developing Countries, 1978-1990 (billions of dollars)

13. Emergence of the 1980s Debt Crisis • Developing countries essentially were left with two options: (1) to impose restrictive fiscal and monetary policy and curtail imports to reduce foreign spending, thus also reducing economic growth, or (2) finance the growing debt obligations with even more borrowing. • Many countries were unwilling, or sometimes just unable to exercise the first option, so they resorted to further borrowing. Eventually the debt obligations of developing countries were so high that they could no longer borrow in private markets, and their debt servicing costs were exceeding new loans being procured by 1984. • The situation led to the increasing adoption of IMF stabilisation policies; often a necessary first step before international banks would be willing to renegotiate loan repayment terms.

14. IMF Stabilization Policies and Their Critics • The typical IMF stabilization program has four basic components: • Liberalization of foreign exchange and imports control • Devaluation of the official exchange rate • Stringent domestic anti-inflation program (spending cuts) • Opening up of the economy to international commerce • By 1992 ten countries had signed on to borrow $37.2 billion from the IMF, conditional on implementing at least some of the above policies. IMF conditional loans were drawn upon even more with the East Asian crisis in 1997 and the global financial crisis in 2008. • These stabilisation policies can cause political instability, because they can directly harm the poor and middle classes in adopting countries. They can also be seen as hypocritical, as the largest debtor in the world the United States is never subjected to conditionalities. The IMF is also sometimes perceived as representing corporate interests in developed countries, which provide the largest source of finance.

15. IMF Stabilization Policies and Their Critics • The debt crisis of the 1980s was effectively begun by Mexico’s moratorium on debt payments in 1982. This called into question the viability of the international financial system, and raised fears that indebted countries could form a debtor’s cartel and affect repayments to developed countries. • The most notable attempt at restructuring debt incurred from foreign governments has been the Paris Club arrangements, offering highly concessional terms known as the Toronto terms. The three options offered are cancellation of up to one-third of non-concessional debt, reduced interest rates, and extended maturity of loans up to 25 years. • For loans from commercial banks, the 1989 Brady Plan proposed partial debt forgiveness and IMF/World Bank assistance conditional on acceptance of IMF stabilisation programmes, promoting free markets and foreign investment, and repatriating foreign capital.

16. IMF Stabilization Policies and Their Critics • A method of debt reduction with commercial banks employed extensively in Latin America is via debt-for-equity swaps. This involves the selling of commercial bank debt holdings in developing countries to private investors at a large discount, who then trade the debtor’s obligation to pay for local state-owned assets, which are usually utility companies. • This method was used largely by US commercial banks to reduce their debt holdings in Latin America, as it legally allows them to take a loss on the debt traded away to private investors without reducing the value of other debts held in the developing country in question. It also allows developing countries to reduce their debt while increasing privatisation of local assets. • Potential negative consequences of such debt swaps are increased foreign holdings of local assets at heavily discounted prices could increase dual economy development and reduce local government’s ability to influence the economy.

17. Global Current Account Imbalances

18. Global Financial Crisis and Developing Countries • Causes of the crisis within the financial system: • Deregulation of rules in the US that separated commercial and investment banking, and no regulation of new financial instruments. • Public policy encouraging home ownership through subprime lending. • Support of subprime lending via implicit government guarantees on enterprises such as Freddie Mac and Fannie Mae. • Repackaging and reselling of subprime debt internationally as securities whose risk was purposely and systematically undervalued. • All of the above created a fragile, highly leveraged financial system with little understanding of the financial instruments being traded. • Parallel, similar financial stability problems in Europe. • Basel III agreement of 2010 and other legislation are first steps towards rectifying these problems.

19. Global Financial Crisis and Developing Countries • A second factor behind the crisis is the chronic trade imbalance between East Asia (mainly China) and the developed countries (mainly US). China and the East Asian countries deposited their export earnings in developed country banks, providing cheap capital to fuel the housing bubble. • This crisis is unique, as previously financial crises were assumed to originate in developing countries. Also for the first time sovereign debt is being seen as a problem in developed EU countries. • The outsize share of the US in world imports means the global recovery depends heavily on US growth. Also over-reliance on exports to the US for growth has led to competitive depreciation of many developing country currencies, which could prevent US trade imbalances being corrected and delay the recovery.

20. Global Financial Crisis and Developing Countries • Economic impacts on developing countries: • Economic growth in developing countries did not slow as much as in developed countries, as their financial systems were not as closely linked to those in the US and Europe. • Exports fell drastically initially, with world trade volumes declining by 14.4% in 2009. Developing countries in particular faced a drop in export values of 31% in 2009, compared to a 23% average drop worldwide. A declining US dollar could also mean lower export growth in the future, as could increasing developed country protectionism to build savings and cut spending. • Foreign investment inflows declined by 27% in developing countries in 2009 after six years of uninterrupted growth, but this was still less than the 44% decline in developed countries. In Africa, foreign investment flows declined overall, but the composition of investors has shifted towards emerging economies like China.

21. Global Financial Crisis and Developing Countries • Poverty has increased in developing countries as a result of the recession, with World Bank estimates showing that 50 million additional people will be below the poverty line in 2009 due to the recession. The number of people living with extreme hunger also surpassed 1 billion for the first time in 2009. • Differing impacts across developing regions: • China has shifted focus from exports to increasing domestic demand to maintain economic growth with falling exports. However there are emerging problems with inflation and a potential housing bubble of its own. China is also facing pressure to allow its currency to appreciate at a time when the world is competing for export markets, and the US is attempting to restore trade balances and continue acting as the major global importer. • East Asia is still dependent on exports for growth, so the 25% decline in exports in dollar value between the second half of 2008 and the first half of 2009 led to a 15-30% fall in GDP. However strong import demand from China, mainly for infrastructural raw materials has led to a strong recovery for many of these countries.

22. Global Financial Crisis and Developing Countries • India has not suffered as much as other countries due to barriers to global financial flows. Growth has reduced somewhat from 9.5% before the crisis to between 7-8%, which is not a major slowdown. However the government did run a large fiscal deficit of nearly 7% of GDP during the crisis to maintain demand levels, and the government debt was as high as 82% of GDP in 2010. These debt levels will need to be scaled back as demand recovers. • Despite concerns of a repeat of past debt crises, most Latin American countries have come through the crisis shock unscathed. The exception is Mexico, which suffered an economic contraction of 6.5% in 2009 mainly due to close economic ties to the faltering US as well as the outbreak of the H1N1 flu virus. However a recovery is projected for the current period. • Africa has been largely insulated from the crisis due to low trade levels and little engagement with financial markets. There have been some problems with educated unemployment increasing, but high demand from Asia has kept commodity prices high and fueled growth.

23. Global Financial Crisis and Developing Countries • Prospects for recovery and stability for the first time in history depend on developing countries. The risks are still significant for the crisis recurring, for five main reasons: • The US trade deficit is still large, but relying on the US demand for imports for world growth is risky given the fragile state of its economy and reduced demand after the crisis. • Fiscal deficits are also high in all OECD countries, making them an unlikely replacement market for developing country exports. Loose monetary policy means little leeway to increase demand from further interest rate cuts. • Market perception of sovereign default risk is high for some developed countries. A decrease in credit to troubled EU economies now could lead to another global financial crisis. • The risk of deflation due to low global demand is high, and this could lead to reduced dollar values that could hurt developing country exports by making them relatively more expensive.

24. Global Financial Crisis and Developing Countries • Tighter credit constraints and disguised forms of protectionism may reduce developing country exports of manufactures to developed countries, and also may slow down technology transfer and growth. • The crisis has provided an opportunity for developing countries to take the lead in restoring global economic growth, especially with China emerging as a regional engine of growth as a replacement market for exports. Emerging Asian economies are also becoming more important as sources of foreign capital for Africa, giving them an increased role in decreasing global poverty.