Microsoft PowerPoint – C22_ECON7520_week12
Chapter 22
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Developing Countries:
Growth, Crisis, and Reform
Instructor:
Learning Objectives
22.1 Describe the persistently unequal world distribution of
income and the evidence on its causes.
22.2 Summarize the major economic features of developing
countries.
22.3 Explain the position of developing countries in the world
capital market and the problem of default by developing
borrowers.
22.4 Recount the recent history of developing-country financial
22.5 Discuss proposed measures to enhance poorer countries’
gains from participation in the world capital market
• Snapshots of rich and poor countries
• Characteristics of poor countries
• Borrowing and debt in poor and middle-income economies
• The problem of “original sin”
• Types of financial assets
• Latin American, East Asian, and Russian crises
• Currency boards and dollarization
• Lessons from crises and potential reforms
• Geography’s and human capital’s role in poverty
The Gap Between Rich and Poor
• Low income: most sub-Saharan Africa, India, Pakistan
• Lower-middle income: China, Caribbean countries
• Upper-middle income: Brazil, Mexico, Saudi Arabia,
Malaysia, South Africa, Czech Republic
• High income: United States, Singapore, France, Japan,
Table 22.1 Indicators of Economic
Welfare in Four Groups of Countries
Income Group
GDP per Capita
(2019 U.S. dollars)
Life Expectancy in
2018 (years)
Low-income 780 63
Lower middle-income 2,177 68
Upper middle-income 9,040 75
High-income 44,584 81
Source: World Bank, World Development Indicators.
Has the World Income Gap Narrowed
Over Time?
• While some previously middle- and low-income
economies have grown faster than high-income countries,
and thus have “caught up” with high-income countries,
others have languished.
– The income levels of high-income countries and some
previously middle-income and low-income countries
have converged.
– But the some of the poorest countries have had the
lowest growth rates.
Table 22.2 Output per Capita in Selected
Countries, 1960–2017 (in 2011 U.S. Dollars) (1 of 4)
Industrialized in 1960
Country Output per Capita 1960 Output per Capita 2017
Annual Average
Growth Rate
(percent per year)
Canada 15,573 44,975 1.9
France 11,344 38,170 2.2
Germany 13,337 46,349 2.2
Italy 10,176 35,668 2.2
Japan 6,400 39,381 3.2
Spain 7,301 33,593 2.7
Sweden 14,478 45,844 2.0
United Kingdom 12,719 38,153 1.9
United States 17,319 54,586 2.0
Table 22.2 Output per Capita in Selected
Countries, 1960–2017 (in 2011 U.S. Dollars) (2 of 4)
Country Output per Capita 1960 Output per Capita 2017
Annual Average
Growth Rate
(percent per year)
Kenya 1,952 3,090 0.8
Nigeria 2.665 5,270 1.2
Senegal 2.917 3,111 0.1
South Africa 7,204 12,004 0.9
Zimbabwe 1,132 1,914 0.9
Table 22.2 Output per Capita in Selected
Countries, 1960–2017 (in 2011 U.S. Dollars) (3 of 4)
Latin America
Country Output per Capita 1960 Output per Capita 2017
Annual Average
Growth Rate
(percent per year)
Argentina 9,283 16,432 1.0
Brazil 3,995 14,066 2.2
Chile 5,734 22,123 2.4
Colombia 4,059 13,585 2.1
4,329 14,712 2.2
Mexico 6,633 16,792 1.6
Paraguay 2,618 8,948 2.2
Peru 5,135 11,808 1.5
Venezuela 11,935 11,321 negative 0.10.1
Table 22.2 Output per Capita in Selected
Countries, 1960–2017 (in 2011 U.S. Dollars) (4 of 4)
Output per Capita
Output per Capita
Annual Average Growth Rate
(percent per year)
China 815 13,465 5.0
4,459 50,271 4.3
India 1,048 6,548 3.3
Indonesia 1,635 11,173 3.4
Malaysia 2,639 24,574 4.0
Singapore 4,368 69,150 5.0
South Korea 1,573 36,999 5.7
Taiwan 2,070 43,501 5.5
Thailand 1,162 14,884 4.7
Note: Data are taken from the Penn World Table, Version 9.1, and use PPP exchange rates to compare national incomes
(variables RGDPNA/POP). For a description, see the Penn World Table website at
https://www.rug.nl/ggdc/productivity/pwt/ .
Structural Features of Developing
Countries (1 of 5)
• What causes poverty is a difficult question, but low-income
countries have at least some of following characteristics, which
could contribute to poverty:
1. Government control of the economy
– Restrictions on trade
– Direct control of production in industries and a high level of
government purchases relative to GNP
– Direct control of financial transactions
– Reduced competition reduces innovation; lack of market
prices prevents efficient allocation of resources
Figure 22.1 Have Become
Less Important for Global GDP Growth
As many developing countries have grown more quickly and come to account for larger
shares of world output, their GDP growth rates have become more important in
determining overall world growth. At the same time, growth in the richer economies has
tended to slow over time.
Source: IMF, World Economic Outlook. The group of “advanced economies” in the
chart excludes Japan, Germany, and United States, which are shown separately. World
growth is calculated using GDP weights, with GDP measured at market prices. Partial
data for the 2010s.
Structural Features of Developing
Countries (2 of 5)
2. Unsustainable macroeconomic policies that cause high
inflation and unstable output and employment
– If governments cannot pay for debts through taxes, they
can print money to finance debts.
– Seigniorage is paying for real goods and services by
printing money.
– Seigniorage generally leads to high inflation.
– High inflation reduces the real cost of debt that the
government has to repay and reduces the real value of
repayments for lenders.
– High and variable inflation is costly to society; unstable
output and employment is also costly.
Structural Features of Developing
Countries (3 of 5)
3. Lack of financial markets that allow transfer of funds from savers to
– Banks frequently lend funds to poor or risky projects.
– Loans may be made on the basis of personal connections
rather than prospective returns, and government safeguards
against financial fragility, such as bank supervision, tend to be
ineffective due to incompetence, inexperience, and outright
– Usually harder in developing countries for shareholders to find
out how a firm’s money is being spent or to control firm
– The legal framework for resolving asset ownership in cases of
bankruptcy typically is also weak.
Structural Features of Developing
Countries (4 of 5)
4. Where exchange rates are not pegged outright (as in China), they
tend to be managed more heavily by developing-country
governments. Government measures to limit exchange rate flexibility
reflect both a desire to keep inflation under control and the fear that
floating exchange rates would be subject to huge volatility in the
relatively thin markets for developing-country currencies. There is a
history of allocating foreign exchange through government decree
rather than through the market, a practice (called exchange control)
that some developing countries still maintain. Most developing
countries have, in particular, tried to control capital movements by
limiting foreign exchange transactions connected with trade in assets.
More recently, however, many emerging markets have opened their
capital accounts.
Structural Features of Developing
Countries (5 of 5)
5. Natural resources or agricultural commodities make up an
important share of exports for many developing countries.
– For example, Russian petroleum, Malaysian timber, South
African gold, and Colombian coffee.
6. Attempts to circumvent government controls, taxes, and
regulations have helped to make corrupt practices such as
bribery and extortion a way of life in many developing countries.
– Due to government control of the economy and weak
enforcement of economic laws and regulations,
underground economies and corruption flourish.
Figure 22.2 Corruption and Per Capita
Corruption tends to rise as real per capita output falls.
Note: The figure plots 2018 values of an (inverse) index of corruption and 2018 values of PPP-adjusted
real per capita output, measured in constant 2010 U.S. dollars (the amount a dollar could buy in the
United States in 2010). The straight line represents a statistician’s best guess of a country’s corruption
level based on its real per capita output.
Source: Transparency International, Corruption Perception Index; World Bank, World Development
Indicators.
Developing-Country Borrowing and Debt
• Another common characteristic for many low- and middle-income
countries is that they have traditionally borrowed from foreign
countries.
– Financial asset flows from foreign countries are able to finance
investment projects, eventually leading to higher production and
consumption.
– But some investment projects fail and other borrowed funds are
used primarily for consumption purposes.
– Some countries have defaulted on their foreign debts when the
domestic economy stagnated or during financial crises.
– But this trend has recently reversed as these countries have
begun to save.
The Economics of Financial Inflows to
Developing Countries
• national saving investment the current account
– where the current account is approximately equal to
the value of exports minus the value of imports.
• Countries with national saving less than domestic
investment will have financial asset inflows and a
negative current account (a trade deficit).
The Problem of Default (1 of 6)
A financial crisis may involve
1. a debt crisis: an inability to repay sovereign
(government) or private sector debt.
2. a balance of payments crisis under a fixed exchange
rate system.
3. a banking crisis: bankruptcy and other problems for
private sector banks.
The Problem of Default (2 of 6)
• A debt crisis in which governments default on their debt
can be a self-fulfilling mechanism.
– Fear of default reduces financial asset inflows and
increases financial asset outflows (capital flight),
decreasing investment and increasing interest rates,
leading to low aggregate demand, output, and
– Financial asset outflows must be matched with an
increase in net exports or a decrease in official
international reserves in order to pay individuals and
institutions who desire foreign funds.
The Problem of Default (3 of 6)
– Otherwise, the country cannot afford to pay those
who want to remove their funds from the domestic
– The domestic government may have no choice but to
default on its sovereign debt (paid for with foreign
funds) when it comes due and when investors are
unwilling to reinvest.
The Problem of Default (4 of 6)
• In general, a debt crisis can quickly magnify itself: it
causes low income and high interest rates, which make
government and private sector debts even harder to
– High interest rates cause high interest payments for
both the government and the private sector.
– Low income causes low tax revenue for the
government.
– Low income makes loans made by private banks
harder to repay: the default rate increases, which may
cause bankruptcy.
The Problem of Default (5 of 6)
• If the central bank tries to fix the exchange rate, a balance of
payment crisis may result along with a debt crisis.
– Official international reserves may quickly be depleted because
governments and private institutions need to pay for their debts
with foreign funds, forcing the central bank to abandon the fixed
exchange rate.
• A banking crisis may result from a debt crisis.
– High default rates on loans made by banks reduce their income
to pay for liabilities and may increase bankruptcy.
– If depositors fear bankruptcy due to possible devaluation of the
currency or default on government debt (assets for banks), then
they will quickly withdraw funds from banks (and possibly
purchase foreign assets), leading to actual bankruptcy.
The Problem of Default (6 of 6)
• A debt crisis, a balance of payments crisis, and a banking
crisis can occur together, and each can make the other
– Each can cause aggregate demand, output, and
employment to fall (further).
• If people expect a default on sovereign debt, a currency
devaluation, or bankruptcy of private banks, each can
occur, and each can lead to another.
Alternative Forms of Financial Inflow (1 of 3)
1. Bond finance: government or private sector bonds are
sold to foreign individuals and institutions.
2. Bank finance: commercial banks or securities firms
lend to foreign governments or foreign businesses.
3. Official lending: the World Bank, Inter-American
Development Bank, or other official agencies lend to
governments.
– Sometimes these loans are made on a “concessional”
or favorable basis, in which the interest rate is low.
Alternative Forms of Financial Inflow (2 of 3)
4. Foreign direct investment: a firm directly acquires or
expands operations in a subsidiary firm in a foreign
– A purchase by Ford of a subsidiary firm in Mexico is
classified as foreign direct investment.
5. Portfolio equity investment: a foreign investor
purchases equity (stock) for his portfolio.
– Privatization of government-owned firms in many
countries has created more equity investment
opportunities for foreign investors.
Alternative Forms of Financial Inflow (3 of 3)
• Debt finance includes bond finance, bank finance, and
official lending.
• Equity finance includes direct investment and portfolio
equity investment.
• While debt finance requires fixed payments regardless of
the state of the economy, the value of equity finance
fluctuates depending on aggregate demand and output.
The Problem of “Original Sin” (1 of 4)
• Sovereign and private sector debts in the United States,
Japan, and European countries are mostly denominated
in their respective currencies.
• But when poor and middle-income countries borrow in
international financial capital markets, their debts are
almost always denominated in US $, yen, or euros: a
condition called “original sin.”
The Problem of “Original Sin” (2 of 4)
• When a depreciation of domestic currencies occurs in the
United States, Japan, or European countries, liabilities
(debt) that are denominated in domestic currencies do
not increase, but the value of foreign assets increases.
– A devaluation of the domestic currency causes an
increase in net foreign wealth.
The Problem of “Original Sin” (3 of 4)
• When a depreciation/devaluation of domestic currencies
occurs in most poor and middle-income economies, the
value of their liabilities (debt) rises because their liabilities
are denominated in foreign currencies.
– A devaluation of the domestic currency causes a
decrease in net foreign wealth.
The Problem of “Original Sin” (4 of 4)
– In particular, a fall in aggregate demand of domestic
products causes a depreciation/devaluation of the
domestic currency and causes a decrease in net
foreign wealth if assets are denominated in domestic
currencies and liabilities (debt) are denominated in
foreign currencies.
– This is a situation of “negative insurance” against a
fall in aggregate demand.
The Debt Crisis of the 1980s (1 of 2)
• In the 1980s, high interest rates and an appreciation of
the U.S. dollar caused the burden of dollar-denominated
debts in Argentina, Mexico, Brazil, and Chile to increase
drastically.
• A worldwide recession and a fall in many commodity
prices also hurt export sectors in these countries.
• In August 1982, Mexico announced that it could not repay
its debts, mostly to private banks.
The Debt Crisis of the 1980s (2 of 2)
• The U.S. government insisted that the private banks
reschedule the debts, and in 1989 Mexico was able to
– a reduction in the interest rate
– an extension of the repayment period
– a reduction in the principal by 12%
• Brazil, Argentina, and other countries were also allowed
to reschedule their debts with private banks after they
defaulted.
Reforms, Capital Inflows, and the Return
of Crisis (1 of 9)
• The Mexican government implemented several reforms
due to the crisis. Starting in 1987, it
– reduced government deficits.
– reduced production in the public sector (including
banking) by privatizing industries.
– reduced barriers to trade.
– maintained an adjustable fixed exchange rate
(“crawling peg”) until 1994 to help curb inflation.
Reforms, Capital Inflows, and the Return
of Crisis (2 of 9)
• It extended credit to newly privatized banks with loan
– Losses were a problem due to weak enforcement or
lack of asset restrictions and capital requirements.
• Political instability and loan defaults at private banks
contributed to another crisis in 1994, after which the
Mexican government allowed the value of the peso to
fluctuate.
Reforms, Capital Inflows, and the Return
of Crisis (3 of 9)
• Starting in 1991, Argentina carried out similar reforms:
– It reduced government deficits.
– It reduced production in the public sector by
privatizing industries.
– It reduced barriers to trade.
– It enacted tax reforms to increase tax revenues.
– It enacted the Convertibility Law, which required that
each peso be backed with 1 U.S. dollar, and it fixed
the exchange rate to 1 peso per U.S. dollar.
Reforms, Capital Inflows, and the Return
of Crisis (4 of 9)
• Because the central bank was not allowed to print more
pesos without having more dollar reserves, inflation
slowed dramatically.
• Yet inflation was about 5% per annum, faster than U.S.
inflation, so that the price/value of Argentinean goods
appreciated relative to U.S. and other foreign goods.
• Due to the relatively rapid peso price increases, markets
began to speculate about a peso devaluation.
• A global recession in 2001 further reduced the demand of
Argentinean goods and currency.
Reforms, Capital Inflows, and the Return
of Crisis (5 of 9)
• Maintaining the fixed exchange rate was costly because
high interest rates were needed to attract investors,
further reducing investment and consumption
expenditure, output, and employment.
• As incomes fell, tax revenues fell and government
spending rose, contributing to further peso inflation.
Reforms, Capital Inflows, and the Return
of Crisis (6 of 9)
• Argentina tried to uphold the fixed exchange rate, but the
government devalued the peso in 2001 and shortly
thereafter allowed its value to fluctuate.
• It also defaulted on its debt in December 2001 because
of the unwillingness of investors to reinvest when the
debt was due.
Reforms, Capital Inflows, and the Return
of Crisis (7 of 9)
• Brazil carried out similar reforms in the 1980s and 1990s:
– It reduced production in the public sector by
privatizing industries.
– It reduced barriers to trade.
– It enacted tax reforms to increase tax revenues.
– It fixed the exchange rate to 1 real per U.S. dollar.
– But government deficits remained high.
Reforms, Capital Inflows, and the Return
of Crisis (8 of 9)
• High government deficits led to inflation and speculation
about a devaluation of the real.
• The government did devalue the real in 1999, but a
widespread banking crisis was avoided because Brazilian
banks and firms did not borrow extensively in dollar-
denominated assets.
Reforms, Capital Inflows, and the Return
of Crisis (9 of 9)
• Chile suffered a recession and financial crisis in the
1980s, but thereafter
– enacted stringent financial regulations for banks.
– removed the guarantee from the central bank that
private banks would be bailed out if their loans failed.
– imposed controls on flows of short-term assets, so
that funds could not be quickly withdrawn during a
financial panic.
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