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XIX. Developing countries. Growth, crisis, defaults. 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

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Xix developing countries

XIX. Developing countries

Growth, crisis, defaults

Macro policies for developed industrialized countries
Macro policies fordeveloped (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

Xix 1 developing economies
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.

First important period after 1960
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

Macro features after the end of b w system
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

Structural changes
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

Xix 2 balance of payments crisis
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

Remember lxii
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

Crisis and capital flight
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


Ee,1 > Ee,0







r1 = r*+(Ee,1-E0)/E0


Expected returns

(domestic, foreign)






Bop crisis mechanics
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


  • 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

Xix 3 debts and banking crisis
XIX.3 Debts and banking crisis

  • Developing countries – savings lower than investment (see XIX.1 above) : S – I = CA

  • But S (total savings) =

    Sp (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?

Financial flows into developing countries
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)

Denominating currency
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

Bank runs
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

Xix 4 sudden stop
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”

Different countries in different periods
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)

Literature to lxix
Literature to LXIX

  • Krugman, Obstfeld, Ch. 18, 19 and 22 and readings there