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CHAPTER 22 Developing Countries: Growth, Crisis, and Reform Chapter Organization Income and Wealth in the World Economy The Gap Between Rich and Poor Has the World Income Gap Narrowed? Structural Features of Developing Countries Developing Country Borrowing and Debt The Economics of Capital Inflows to Developing Countries The Problem of Default Alternative Forms of Capital Inflow Latin America: From Crisis to Uneven Reform Inflation and the 1980s Debt Crisis in Latin America Box: The Simple Algebra of Moral Hazard Case Study: Argentina’s Economic Stagnation and Recovery Reforms, Capital Inflows, and the Return of Crisis East Asia: Success and Crisis The East Asian Economic Miracle Box: What Did Asia Do Right? Asian Weaknesses The Asian Financial Crisis Crises In Other Developing Regions Case Study: Can Currency Boards Make Fixed Exchange Rates Credible? Lessons of Developing Country Crises Reforming the World’s Financial Architecture Capital Mobility and the Trilemma of the Exchange Rate Regime Prophylactic Measures Coping With Crisis A Confused Future Summary Chapter Overview This chapter provides the theoretical and historical background students need to understand the macroeconomic characteristics of developing countries, the problems these countries face, and some proposed solutions to these problems. Students should be aware of the general events of the East Asian financial crisis. The chapter covers the East Asian growth miracle and subsequent financial crisis in depth. First, though, it introduces general characteristics of developing countries and the economics of their extensive borrowing on world markets, as well as the inflation experiences, debt crisis, and subsequent reform in Latin America. The chapter begins by discussing how the economies of developing countries differ from industrial economies. The wide differences in per capita income and life expectancy across different classes of countries is striking. Some economic theories predict growth convergence, and there is evidence of such a pattern among industrialized nations, but no clear pattern emerges among developing countries. Some have grown rapidly while others have struggled. There are important structural differences between developing economies and industrial economies. Governments in developing countries have a pervasive role in the economy, setting many prices and limiting transactions in a wide variety of markets; this can contribute to higher levels of corruption. These governments often finance their budget deficits through seigniorage, leading to high and persistent inflation. The economies of developing countries are typically not well diversified, with a small number of commodities providing the bulk of exports. These commodities, which may be natural resources or agricultural products, have extremely variable prices. Finally, economies of developing countries typically lack developed financial markets and often rely on fixed exchange rates and capital controls. There is a discussion of the use of seigniorage in developing countries in the text. You may want to use the discussion of seigniorage in the text as a springboard for a more in-depth discussion of this topic. In particular, you could present a model of where seigniorage revenue is a function of the inflation rate chosen. The function is concave, at first increasing but eventually decreasing as high inflation leads people to hold less money. It is much like the Laffer curve for taxation. This helps explain how similar seignorage revenues may come from widely different inflation levels. Figure 22-1 In principle, developing countries (and the banks lending to them) should enjoy large gains from intertemporal trade. Developing countries, with their rich investment opportunities relative to domestic saving, can build up their capital stocks through borrowing. They can then repay interest and principal out of the future output the capital generates. Developing-country borrowing can take the form of equity finance, direct foreign investment, or debt finance, including bond finance, bank loans, and official lending. These gains from intertemporal trade are threatened by the possibility of default by developing countries. Developing countries have defaulted in many situations over time, from nineteenth century American states to most developing countries in the Depression to the debt crisis in the 1980s. If lenders lose confidence, they may refuse further lending, forcing developing countries to bring their current account into balance. These crises are driven by similar self-fulfilling mechanisms as exchange rate crises or bank runs and the discussion of debt default provides an opportunity to revisit the ideas of currency crises and bank runs before a full-fledged discussion of the East Asian crisis. The next section of the chapter focuses on the experiences of Latin America. In the 1970s, inflation became a widespread problem in Latin America, and many countries tried using a tablita, or crawling peg. The strategy, though, did not stop inflation and large real appreciations were the result. Government guaranteed loans were widespread leading to moral hazard (discussed in a box on Chile). By the early 1980s, collapsing commodity prices, a rising dollar, and high U.S. interest rates precipitated default in Mexico followed by other developing countries. After the debt crisis stretched through most of the decade and slowed developing country growth in many regions, debt renegotiations finally loosened burdens on many countries by the early 1990s. After the debt crisis appeared to be ending, capital began to flow back into many developing countries. These countries were finally undertaking serious economic reform to stabilize their economy. The chapter details these efforts in Argentina, Brazil, Chile, and Mexico, and also discusses how crisis unfortunately returned to some of these countries. Next, the chapter covers the success and subsequent crisis in Asia (Chapter 10 also touches on this subject). The causes of success, such as high savings, strong education, stable macroeconomics, and high levels of trade are considered. Some aspects of the economies that remained weak, such as low productivity growth and weak financial regulation are also discussed. The crisis, beginning in August 1997, is explained in detail along with its spread to other developing countries. The lessons of these years of growth and crisis are summarized as: choosing the right exchange rate regime, the importance of banking, proper sequencing of reforms, and the importance of contagion. A box then considers whether currency boards can make fixed exchange rates more sustainable. These experiences have emphasized the policy trilemma discussed in Chapter 21 and led to calls for reform of the world’s financial architecture. The chapter concludes by considering some of these, from preventative measures to reduce the risk of crises, to measures that improve the way crises are handled (such as reforming the IMF). Answers to Textbook Problems 1. The amount of seigniorage governments collect does not grow monotonically with the rate of monetary expansion. The real revenue from seigniorage equals the money growth rate times the real balances held by the public. But higher monetary growth leads to higher expected future inflation and (through the Fisher effect) to higher nominal interest rates. To the extent that higher monetary growth raises the nominal interest rate and reduces the real balances people are willing to hold, it leads to a fall in real seigniorage. Across long-run equilibriums in which the nominal interest equals a constant real interest rate plus the monetary growth rate, a rise in the latter raises real seigniorage revenue only if the elasticity of real money demand with respect to the expected inflation rate is greater than -1. Economists believe that at very high inflation rates this elasticity becomes very negative (quite large in absolute value). 2. As discussed in the answer to problem 1, the real revenue from seigniorage equals the money growth rate times the real balances held by the public. Higher monetary growth leads to higher expected future inflation, higher nominal interest rates, and a reduction in the real balances people are willing to hold. In a year in which inflation is 100 percent and rising, the amount of real balances people are willing to hold is less than in a year in which inflation is 100 percent and falling; thus seigniorage revenues will be higher in 1980, when inflation is falling, than in 1990, when inflation is rising. 3. Although Brazil's inflation rate averaged 147 percent between 1980 and 1985, its seigniorage revenues, as a percentage of output, were less than half the seigniorage revenues of Sierra Leone, which had an average inflation rate of 43 percent. Since seigniorage is the product of inflation and real balances held by the public, the difference in seigniorage revenues reflects lower holdings of real balances in Brazil than in Sierra Leone. In the face of higher inflation, Brazilians find it more advantageous than residents of Sierra Leone to economize on their money holdings. This may be reflected in a financial structure in which money need not be held for very long to make transactions due to innovations such as automatic teller machines. 4. Under interest parity, the nominal interest rate of the country with the crawling peg will exceed the foreign interest rate by 10 percent since expected currency depreciation (equal to 10 percent) must equal the interest differential. If the crawling peg is not fully credible, the interest differential will be higher as the possibility of a large devaluation makes the expected depreciation larger than the announced 10 percent. 5. Capital flight exacerbates debt problems because the government is left holding a greater external debt itself but may be unable to identify and tax the people who bought the central-bank reserves that are the counterpart of the debt, and now hold the money in foreign bank accounts. To service its higher debt, therefore, the government must tax those who did not benefit from the opportunity to move funds out of the country. There is thus a change in the domestic income distribution in favor of people who are likely to be quite well-off already. Such a regressive change may trigger political problems. 6. There may have been less lending available to private firms than to state-owned firms if lenders felt that state guarantees ensured repayment by state-owned firms. (In some cases, such as that of Chile, however, the government was pressured ex post into taking over the debts even of private borrowers.) Private firms may also have faced more discipline from the market -- their operating losses are unlikely to be covered with public revenues. Private firms would therefore have had to restrict borrowing to investment projects of high quality. 7. By making the economy more open to trade and to trade disruption, liberalization is likely to enhance an developing country's ability to borrow abroad. In effect, the penalty for default is increased. In addition, of course, a higher export level reassures prospective lenders about the country's ability to service its debts in the future. Finally, by choosing policies which international lenders consider sound, such as open markets, countries improve lenders assessment of their credit-worthiness. 8. Cutting investment today will lead to a loss of output tomorrow, so this may be a very short-sighted strategy. Political expediency, however, makes it easier to cut investment than consumption. 9. Peter Kenen first proposed the IDDC plan in 1983, before there was a secondary market for debt. Even with a secondary market, there is scope for the IDDC to help debtor countries since it would alter the terms of their loans and provide some debt relief. There are some potential problems with the IDDC. First, the debt that banks would be willing to sell to the IDDC is that which is least likely to be repaid. Kenen argues that this problem could be avoided by forcing banks to sell baskets of debt, offering some or all of their claims on all participating debtor countries. There is also the so-called moral hazard problem; a debt relief scheme would invite debtors to pursue policies that would increase rather than reduce the size of their debt. Another obstacle is the free-rider problem; if one bank believes that other banks or the IDDC will grant debt relief, which improves the debtor's ability to repay, there is an incentive for that bank to demand a higher price from the IDDC, or to refuse to participate in the IDDC scheme. 10. If Argentina dollarizes its economy, it will buy dollars from the United States with goods, services, and assets. This is, in essence, giving the US Federal Reserve assets for green paper to use as domestic currency. Since Argentina already operates a currency board holding U.S. bonds as its assets, dollarization would not be as radical as it would be for a country whose central banks hold domestic assets. Argentina can trade the U.S. bonds it holds for dollars to use as currency. When money demand increases, the currency board cannot simply print pesos and exchange them for goods and services, it must sell pesos and buy U.S. government bonds. So in switching to dollarization, the government has not surrendered its power to tax its own people through seignorage, it already does not have that power. Still, though, through dollarization, Argentina loses interest by holding non-interest bearing dollar bills instead of interest bearing U.S. treasury bonds. Thus, the size of the seignorage given to the United States each year would be the lost interest (the U.S. nominal interest rate times the money stock of Argentina). This comes on top of the fact that any expansion of the money supply requires sending real goods, services, or assets to the United States for dollars (just as they do with bonds under the currency board). This is not a long-run loss because Argentina could cash in those dollars (just as it could the bonds) for goods and services from the United States whenever it wants. So, what they lose is the interest they should be getting every year they hold the dollars. Further Readings Bela Balassa. "Adjustment Policies in Developing Countries: A Reassessment." World Development, 12 (September 1984), pp. 955-972. Guillermo A. Calvo and Carmen M. Reinhart. “Fear of Floating.” Quarterly Journal of Economics 117 (May 2002). Paul Collier and Jan Willem Gunning. “Explaining African Economic Performance.” Journal of Economic Literature 37 (March 1999), pp. 64-111. Susan M. Collins. "Multiple Exchange Rates, Capital Controls, and Commercial Policy," in Rudiger Dornbusch and F. Leslie C.H. Helmers, eds., The Open Economy: Tools for Policymakers in Developing Countries. New York: Oxford University Press (for the World Bank), 1988. Sebastian Edwards. Crisis and Reform in Latin America: From Despair to Hope. Oxford: Oxford University Press, 1995. Stanley Fischer. “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic Perspectives 15 (Spring 2001), pp.3-24. Albert Fishlow. "Lessons from the Past: Capital Markets during the 19th Century and the Interwar Period." International Organization, 39 (Summer 1985), pp. 383-439. Peter Kenen. The International Financial Architecture: What’s New? What’s Missing? Washington D.C.: Institute for International Economics, 2001. Charles P. Kindleberger. Manias, Panics, and Crashes: A History of Financial Crises. 3rd edition. New York: John Wiley & Sons, 1996. David S. Landes. The Wealth and Poverty of Nations. New York: Norton, 1999. Ronald I. McKinnon. The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. 2nd edition. Baltimore: Johns Hopkins University Press, 1993. Dani Rodrik. “Getting Interventions Right: How South Korea and Taiwan Grew Rich.” Economic Policy 20 (April 1995), pp. 53-107. Mathematical Postcript These postscripts set out formal mathematical treatments of models presented in earlier chapters. The level of mathematical sophistication is a step above that used in the text; calculus and maximization principles are employed. A prior knowledge of these tools, however, is not necessary for students to work through these postscripts since there is an intuitive explanation of derivatives and maximization. The postscript to Chapter 3 uses the "hat algebra" technique to present the specific factors model. Factor price determination and the effects of a change in relative prices are derived formally. The postscript to Chapter 4 presents a formal treatment of the factor proportions model, again using "hat algebra", to derive the relationship between goods prices and factor prices and to demonstrate the relationship between factor supplies and output. The postscript to Chapter 5 develops a formal presentation of the standard trade model. This presentation, which introduces a utility function, derives the world trading equilibrium, demonstrates its stability, and investigates the effects of economic growth, the transfer problem, and the effects of a tariff using comparative statics analysis. The postscript to Chapter 21 develops a model of international portfolio diversification by a risk-averse investor. Both an analytic and a diagrammatic derivation of the investor's choice of the optimal portfolio is presented. The diagram which is developed is employed to consider the effects of changing rates of return on the investor's choice. PAGE 185 _995191368.doc Inflation rate seignorage revenue