XIX. Developing countries

1. XIX. Developing countries Growth, crisis, defaults

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. E Ee,1 > Ee,0 B1 E0 A1 r*+(Ee,1-E)/E r*+(Ee,0-E)/E r0 r1 = r*+(Ee,1-E0)/E0 L(Y,r) Expected returns (domestic, foreign) M2/P B A M1/P M/P

11. 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

12. Sterilization • 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

13. 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?

14. 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)

15. 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

16. 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

17. 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”

18. 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)

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