2

16. External Debt Crisis External debt is owed to nonresident government,

businesses, and institutions and repayable in foreign currency.

A debt crisis reduces growth in economic welfare. Financial and currency crises in Thailand and

Indonesia, 1997-2001, and Argentina, 2001-2003, reduced output more than the Great Depression.

3

Deficit & loan decline LDCs’ persistent deficit on balance on

goods, services, and income through 1980s & 1990s, and decline in loans at bankers’ standards in the 1990s, contributed to continuing LDC crisis.

4

Dual nature of debt & financial crises For Latin America & middle-income

borrowers: debt owed to commercial lenders.

Sub-Saharan Africa: debt owed primarily to bilateral governments and multilateral lenders.

5

Capital mobility & financial crises

International capital mobility rose in the last quarter of the 20th century

Global foreign exchange transactions $15 billion daily in 1973, $60 billion (1983), $900 billion (1992), and $2 trillion (2000), far in excess of world central bank reserves ($2 billion).

Foreign exchange to trade flows worldwide were 9:1 (1973), 12:1 (1983), 90:1 (1992), and 900:1 (2000).

6

Capital mobility & financial crises

Cross-border capital movements benefited long-term growth of recipients East Asia, Latin America, and Russia.

However, because of potential reverse outflows, especially of portfolio and mutual funds, capital movements increased their vulnerability to crises.

Not surprisingly, financial crises occurred in Mexico (1994), Southeast and East Asia (1997-99), and Argentina (2001-02) following substantial capital-account liberalization & increases in capital flows.

7

Capital mobility & financial crises

Ranciere, Tornell, and Westerman (2003) show that among 52 LDCs, capital-flow liberalizers grew by 2 percentage points faster than nonliberalizers, with bank credit growth responsible for half the advantage.

Despite the 1997-2001 crisis, Thailand’s growth in gross domestic income per person was 4.5 percent compared to 3.3 percent yearly, 1980-2001, for mostly nonliberalizing India, a cumulative difference of more than 50 percent.

8

Definitions of debt service Debt service: the interest and principal

payments due in a given year on long-term debt.

Debt-service ratio: the interest and principal payments/exports of goods and services (in a given year on long-term debt).

9

Origins of debt crises Chronic international balance on goods,

services, & income deficits 1970s through most of 1990s.

Commercial lending increased relative to aid.

LDCs borrowed money cheaply in the 1970s that rolled over when money was tight in the early 1980s.

10

Origins of debt crises Inefficiency & poor national economic

management in some African & Latin American countries.

Widespread adjustment among primary product producers resulted in price collapse.

Floating exchange rate system increased external shocks for LDCs.

11

Origins of debt crises Volatility in the value of leading reserve

currencies. LDC governments compelled to guarantee private

debt. Overvalued domestic currencies & restrictions on

international trade hurt current account balance Substantial capital flight from foreign aid, loans,

and investment.

12

Capital flight Definition: resident capital outflow (cannot

measure readily with definitions characterizing flight as illegal or abnormal).

Propensity to flee from external borrowing as high as 30-50% or more in many LDCs.

13

Capital flight Results from differences in perceived risk-

adjusted returns in source & haven countries. Source countries: slow growth, overvalued

currencies, inflation, confiscatory taxation, limitations on convertibility, poor investment climate, & political instability.

Haven countries: US’s abandonment of income taxation on nonresident bank-deposit interest & much other investment income.

14

Zairian (Congo – Kinshasa) pathology Congo – Brazzaville diamond exporter in

1970s & early 1980s from diamonds smuggled from Congo – Kinshasa.

President Mobutu’s stashing of funds in Swiss banks & Western real estate was enough to pay Zaire’s debt.

Other predatory rulers from failed states had similar problems.

Acquired Investments Deposited in Switzerland is Africa’s second AID epidemic (Africa Research Bulletin 1991).

15

Capital flight may be caboose not locomotive of crisis Capital flight symptomatic of financial

repression & economic underdevelopment not cause of it (de Vries 1987).

Limited policy prescriptions in weak states. In desperate situation, exchange controls

may be essential.

16

US Banking Crisis Early 1980s: US feared complete writeoff

of LDC debts would wipe out many major US commercial banks, with substantial exposure to LDC debt.

Early 1990s: debt repudiations no longer threatened money-center banks of New York City, but little changed in Africa & Latin America.

17

US exposure reduced US reduced exposure to nonperforming

LDC debt by:- reducing commercial bank lending.- some loan writeoffs & write-downs.- Japan & World Bank helped with debt

write-downs.

18

Spreads & risk premiums Commercial banks charge risk premium

for LDC borrowers, a premium that rises with major financial crises.

Premium may vary from interest rates 1-2 percentage points in excess of London Interbank Offered Rate (LIBOR), a virtually riskless interest rate to 15 percentage points.

19

20

Crisis from LDC perspective

Table 16-1 indicates LDC debt increased for more than $1 trillion in late 1980s to $2.3 trillion in 2001.

Severely indebted countries of the 1980s, many from Africa & Latin America, grew slower than countries of any debt classification.

21

Table 16-1. Total External Debt of LDCs (selected years, 1970–2001, in $ billions)

1970 49

1976 157

1982 816

1884 908

1986 1216

1989 1411

1992 1662

1995 2066

1998 2395

1999 2427

2000 2364

2001 2322

Sources: Organization for Economic Cooperation and Development 1988:218; World Bank 1978i:96–97; World Bank

1988i:258–259; World Bank 1993i:170–171; World Bank 2003e.

22

Sub-Saharan Africa in crisis Debt overhang contributed to - fall in health spending, child nutrition, and

infant survival among poor in early 1980s.- Decline in real wages, employment rate, &

health & educational expenditure shares in late 1980s.

23

Sub-Saharan Africa in crisis Tanzania’s President Julius Nyerere

(1985): “Must we starve our children to pay our debt.”

From 1980 to 2000, Africa’s scarce foreign exchange went to debt service rather than socio-economic development, thus increasing child malnutrition and reducing life expectancy.

24

Latin America countries in 1980s Some experienced deterioration in social

indicators during the 1980s. Argentine President Raul Alfonsin (1987): the

West must recognize how “current economic conditions impede our development and condemn us to backwardness. We cannot accept that the south pay for the disequilibrium of the north.”

25

Location of financial crises Mexico (1994), Thailand, Indonesia & South

Korea (1997), Brazil (1998), Russia (1998), Turkey (2000), Argentina (2001).

All except Brazil & Russia reduced GDP the year after the crisis.

Argentina, Indonesia, & Thailand had a fall in GDP of more than 10%. Others reduced output (Figure 17-2).

Indonesia’s poverty rate increased from 16% (1996) to 27% (1999) (World Bank 2003).

26

27

IMF’s Managing Director Camdesus “Adjustment does not have to lower basic

human standards. . . . Unfortunately, . . . poverty groups” [not] represented in government.” (1989)

In practice, Camdesus’s statement exaggerates “the extent to which the Fund . . . has moved from [its] traditional brief.” (Mosley, Harrigan, & Toye 1991).

28

In poorest African countries Majority of population lives close to subsistence

($1/day poverty). Welfare payments to bring the population above

the poverty line would undermine work incentives and prohibitively expensive.

Need something like World Bank’s Social Dimensions of Adjustment Projects (SDA).

Internal politics results in privileged interest groups but not the poor receiving compensation for adjustment.

29

Debt service ratios (DSRs) Severely indebted middle-income countries’ debt

service ratio, 1999-2001, was 81% in Brazil, 67% in Argentina, & 50% in Lebanon, not sustainable.

Argentina defaulted & rescheduled debt 2001-2003

Sub-Sahara’s actual DSR 34%, scheduled DSR 66% (1990): difference reflects substantial default & debt rescheduling and forgiveness.

30

Table 16-2. Global Real GDP Growth, 1981–2003(GDP in 1995 prices and exchange rates; average annual growth in percent)

1981–1990 1991–2000 2001–2003a

Severely indebted LDCs 1.5 3.2 1.0

Moderately indebted LDCs 2.6 0.9 2.4

Less indebted LDCs 3.4 4.7 4.9

Developing countries 2.6 3.3 3.3

Middle income 2.3 3.3 3.1

Low income 4.2 3.1 4.3

High income 3.1 2.5 3.7

aEstimated.

Source: World Bank 2003h:187.

31

Net transfers Net international resource flows

(investment, loans, and grants) minus net international interest payments and profit remittances (p. 564).

World Bank positive net transfers to sub-Saharan Africa (1983-93), although not confirmed as a policy, perhaps for fear of establishing a precedent.

32

Major LDC Debtors Leaders are not necessarily those with worst debt

crisis: In 2001, Brazil ($226 billion), China ($170 billion), Mexico ($158 billion), Russia ($153 billion), Argentina ($137 billion), Indonesia ($136 billion), Turkey ($115 billion), & India ($97 billion).

Only Indonesia, Argentina, Brazil, & Lebanon are classified as severely indebted middle-income countries

Congo (DRC), Ivory Coast, Ethiopia, Nigeria, Sierra Leone (not beneficiaries of Jubilee 2000 write-downs), have debt burdens more difficult to bear than most in Table 16-3.

33

Major debtors Between 1980-January 2002, 78 LDCs

renegotiated foreign debts through multilateral agreements under Paris Club (for official creditor groups) and London Club (for commercial banks.

Not much correlation between renegotiations & largest debtors in Table 16-3.

South Korea, one of largest LDC debtors (until graduated to high-income economy in 1994) because of high credit rating. Still Korea suffered from contagion of 1997 Asian crisis.

34

Financial & Currency Crises Problems: despite benefits of open capital

markets, financial markets often perform poorly when immediately liberalizing, increasing percentage of nonperforming loans, encountering bad credit risks disproportionately eager to take out loans, lacking information on assessing expanded lending, borrowers’ collateral falls from currency devaluation, & interest rates increase sharply.

Asymmetries in information (present in 1990s’ crises) between lender & borrower.

35

Jong-Il You (2002) The IMF has contradictory signals, supporting “

capital account liberalization [that] expos[es] a country to the ebbs and flows of capital that are regulated by the judgement and opinions of international bankers and fund managers. . . . [T]he patent failure of the Fund’s initial rescue operations in the wake of the Asian financial crisis underscored the fact that it was ill-equipped to deal with this new form of crisis.”

36

1990s’ Mexican & Asian crises Large fiscal deficits, inflation, & money

supply not factors in crises. Capital inflows/GDP, bank nonperforming

loan ratios, & current account deficits were high; credit growth was fast; (and except for Korea) the domestic currency (set at a constant nominal rate for several years) had experienced a real appreciation.

37

Krugman & Bhagwati Supported capital controls for Malaysia in 1998

(undertaken soon after their announcement of support).

Malaysia’s recovery was faster. Within a year, Malaysia restored capital

convertibility. However, capital controls “provided a screen

behind which [political cronies and] favored firms could be supported” (Johnson & Mitton).

38

World Bank & IMF adjustment World Bank’s mandate is development

lending to LDCs. IMF lent resources to help DCs & LDCs

cope with balance of payments crises. World Bank sectoral adjustment loans

(SECALs) emphasized reforms in trade, agriculture, industry, public enterprise, finance, energy, education, & other sectors.

39

IMF structural adjustment loans structural adjustment loans: emphasis on

macroeconomic stabilization. Conditionality, a quid pro quo for borrowing,

includes the borrower’s adopting adjustment policies to attain a viable balance of payments.

World Bank and other lenders/donors relied on IMF “seal of approval” for aid, loans, and investment.

40

Fundamentalists vs. Columbia school What are the origins of the Asian crisis, 1997-99? Fundamentalists such as Goldstein (1998)

emphasize financial sector weakness (including inadequate supervision); high bad-debt ratios, large current-account deficits, fixed exchange rates, overvalued currencies, contagion of financial disturbances causing portfolio investors to reassess Asian inventories, increased risky behavior (failure to hedge), and moral hazard from previous international bailouts.

41

Columbia School (Stiglitz-Sachs) Agree with much of fundamentalists’ analysis on

causes but differ on prescription. Fundamentalists want IMF to lend only if

undertake fundamental structural reforms in banking.

Stiglitz thinks it’s unrealistic for IMF to loan short term, expecting reforms that can only be attained in the middle- to long-run.

Legal & institutional preconditions for effective banking supervision, licensing, & regulation & operational independence takes time & resources.

42

Why contagion? Fundamentalists believe that herd behavior of

Western portfolio investors transmitted crisis from one Asian country to another then to Russia & Latin America.

Stiglitz emphasizes Keynesian explanation for contagion, that “belt tightening” imposed by IMF reduced incomes & imports that successively weakened neighbors.

43

Jong-Il You (2002) Having helped generate the financial crises by

urging capital account liberalization in developing and transition economies, the Fund took on the role of firefighters, enlisting the [World] Bank for a supporting role. The quick recoveries of Mexico and Asia . . . are [not] vindication [but] may simply have been a consequence of the fact that the crises were mainly panic-driven. In fact, . . . the [IMF] was ill-equipped to deal with this new form of crisis (ibid.).

44

Stiglitz’s view Initially IMF was to undertake global collective

action to ameliorate market failure. Major task to support economic stability by

spurring growth and reducing unemployment. Stiglitz opposes draconian monetary & fiscal

policies IMF imposes as condition for LDC borrowing. This is against IMF and World Bank’s initial emphasis on expanding employment and combating market failure.

45

Stiglitz Regrets billions of dollars trying to

maintain exchange rates of Brazil & Russia.

Foreigners & rich gain at expense of population at large in debtor country.

IMF more concerned about IMF’s, US Treasury’s, & world financial community’s views than Asian workers & taxpayers.

46

Changing international financial architecture Mistry (1999): rails against IMF monopoly

on crisis management. Need regional arrangements in Asia as in rich countries & Europe. Why did the US oppose an Asian regional monetary fund?

47

International architecture Nayyar (2002): need institution for global

macroeconomic management. Keynes (1944) envisioned International Clearing

Union (became IMF) as clearing house for member debts.

Keynes: IMF should put burden on surplus not deficit economies.

Stiglitz: Keynes must be turning over in his grave.

48

Meltzer Commission (2000) IMF, World Bank, & regional development banks

should write off debts of highly indebted poor countries (HIPCs).

Access to IMF credit automatic & immediate for countries meeting a priori requirements

Bank & development banks should concentrate on poverty reduction

IMF should loan for short-term liquidity not for poverty reduction, aid, or structural reform, for which it is ill suited.

Bush administration embraced but Europeans told Bush that this would erode World Bank resources.

49

IMF failed proposal Stay of payments during crisis (Fischer 1999) IMF’s Sovereign Debt Restructuring Mechanism- Give debtors legal protection (payment

standstill).- Creditor assurances to negotiate in good faith &

support restored growth.- Fresh private lending not restructured.- Verify claims, oversee voting, & adjudicate

disputes.

Collective action clauses (CAC) into new bonds & loans, so single creditor could not undermine debt restructuring process.

50

Resolving debt crisis Debt cancellation. Concerted action. Baker Plan 1985 – new moneys. Brady Plan 1989 – debt reduction &

restructuring, with debt buybacks. Debt exchanges, debt-equity swaps, debt

buybacks, debt-for-nature swaps, debt-for-development swaps, other debt exchanges.

Rescheduling debt.

51

Rescheduling & writing down debt of HIPCs Jubilee 2000: massive writing down of

debt

52

Policy Cartel World Bank, DC governments or

commercial banks require IMF “seal of approval” for macroeconomic stabilization program before lending (Mosley, Harrigan, & Toye 1991).