Chap 2

Emerging countries, their growth and indebtedness and the risk of crisis Chapter 2

What we are going to see in this chapter This chapter is oriented towards development economics • 1) The mechanism of non-development • 2) Characteristics of developing countries • 3) Indebtedness and crises • 4) The various forms of capital flows • 5) Case study: South-East Asia, miracle and weaknesses

1) The mechanics of non development Small income Per capita

Small market No economies of scale

Political instability Weak protection of property rights

Insufficient Investment Weak effiency

Weak productivity

Little capital Few qualified labour

Measuring the gap between rich and poor nations World Bank Statistics 2005

Population (million)

GDP (bn USD)

GNI / capita Market rate

GNI /capita PPP

WORLD

6438

44385

6987

9420

Low income countries

2353

1391

580

2486

Lower middle income

2475

4869

1918

6313

Upper middle income

599

3665

5625

10924

High income countries

1011

34466

35131

32524

LOW & MIDDLE INCOME

5426

9926

1746

5151

East Asia & Pacific

1885

3033

1627

5914

Europe & Central Asia

473

2191

4113

9142

Latin America & Carib.

551

2456

4008

8111

Middle East & North Africa

305

633

2241

6076

1470

996

684

3142

741

615

745

1981

South Asia Sub-Saharan Africa

Explanations to the previous table • Purchasing power parity estimates versus market rate estimates: goods cost the same in all countries, but services cost less in poorer countries; the PPP corrects for that. For Vietnam in 2003, the market ex-rate was 15510 dong /$ whereas the PPP ex-rate was 2783 dong (x5,6) • GDP versus GNI: the GDP reflects the incomes paid by resident units to the factors of production; the GNI reflects the incomes received by the residents (including from abroad). For Vietnam, the difference is marginal: in 2005, GDP/cap = 631$, GNI/cap = 620$

Do poor countries catch up with rich ones? Convergence • The small table below shows the evolution of the GDP per capita between 1950 and 2004 for a limited number of countries. France, Italy, Japan and Spain «converge». 0

1950

2004

growth/year

Argentina

6942

10939

0,8%

France

5921

26168

2,8%

Italy

4217

23175

3,2%

Japan

2188

24661

4,6%

Mexico

2709

8165

2,1%

Nigeria

726

1210

1,0%

Spain

2928

20977

3,7%

Sweden

8507

27073

2,2%

United Kingdom

8082

26762

2,2%

11233

36098

2,2%

4809

7068

0,7%

United States Venezuela

A graph with more countries and the test of « beta-convergence » Beta Convergence of some countries 7% TAIWAN 6%

average yearly growthrate from 1960 to 2003

CHINA

KOREA HONG KONG

5% SINGAPORE THAILAND

MALAYSIA

JAPAN

4%

SPAIN ITALY

3% GHANA

FRANCE

BRASIL

2% MEXICO

UK

CHILE

USA SWEDEN

1% NIGERIA 0%

PERU

ARGENTINA

KENYA

VENEZUELA

SENEGAL -1% 0

2000

4000

6000

8000

GDP per capita in 1960 (in dollars of 2003)

10000

12000

14000

2) Structural features of developing countries All developing countries are different, especially since 1960. But they keep several features in common: b) Strong government intervention, bureaucracy c) Past episodes of high inflation (« inflation tax ») d) Weak financial institutions: opacity of markets, weak governance of banks e) Frequent controls of the foreign exchange markets, in order to avoid excess volatility f) High share of natural resources in exports g) Civil society avoids reglementations and taxes ; corruption

Relation between corruption and the level of development GDP per capita and corruption 2003 3,0 2,5

index of control of corruption (Kaufman)

2,0 1,5 2

R = 0,7439 1,0 VIETNAM 0,5 0,0 -0,5 -1,0 -1,5 -2,0 100

1000

10000 GDP per capita (dollars)

100000

3) Loans, debt and development • The developing countries need to invest, however they have globally not enough savings to do it by themeslves. Thus, they need to borrow from rich countries. • At present, 2755 bn$ debt. From the beginning of the 19-th century until 1997, rich countries financed the development of poorer countries. However, since 1998, the USA became the largest borrower in the world, in order to finance their enormous trade deficit.

3a) Capital flows to developing countries • There is an equality between insufficient savings on the one side, and the deficit of the trade balance on the other side. Trade deficit = I – S • External financing is normal because there are plenty of profitable projects to finance in less developed countries: they borrow resources to invest them

3b) But capital flows may be risky • Loans granted by rich countries are not always well grounded and may lead poor countries to excess debt: non productive investments, purchase of consumption goods etc. • Poor countries may be in a situation where they cannot repay their debts: there is a risk of default. • Vietnam had that in 1986, but many other developing countries fell in default and ran into crises

3c) Three types of crisis A) Debt crisis B) Balance of Payments crisis C) Banking crisis • A) Debt crisis: suppose a country borrows each year 5% of its GDP (T.Def = I – S). If lenders fear a default and stop lending, the country should immediately reduce its deficit of savings to 0% (either by reducing investment, or by raising savings). This triggers a decline of demand and output. The situation may be worse if lenders ask to reimburse previous loans.  SUDDEN STOP

• B) Balance of payments (or exchange) crisis: in order to avoid default, the country may use its foreign exchange reserves. However, this is not compatible with the previous level of the exchange rate, and the country may be forced into devaluation. • C) Banking crisis: holders of bank deposits, fearing a dvaluation, may ask the conversion of their assets into foreign currencies. These mass withdrawals from banks may trigger a banking crisis; note that the financial sector is in a fragile situation from the start. • Conclusion: when all 3 forms of crisis combine, we may have a « snowball effect » (each form of crisis reinforces the others)

4) Various forms of capital flows to developing countries A first distinction is between « sovereign » and private debts. A debt is sovereign when the governement (or Central Bank) borrows or guarantees a liability b) Financing by loans: • Bonds: frequent since 1990 • Bank loans : important in 1970-80 • Official loans (from the WB, ADB, EBRD etc): they bear a low interest rate but are conditional to the implementation of certain reforms

b) Financing by own funds: • Foreign Direct Investments: creation or acquisition of a local firmby a non-resident enterprise. This is the prefered form of financing for developing countries • Portfolio investments: purchase of equity without seeking the control of the local firm c) The problems of « currency mismatch » and « original sin »: developing countrie are obliged to borrow in dollars or euros, whereas rich countries borrow in their own currency. In case of depreciation of their money, poor countries see their debt rise

5) Case study: South East Asia, miracle and weaknesses A) The miracle • The case of South Korea (one of the poorest countries in 1950): beginning of the reforms in 1963, abandon the Import Substitution strategy and pass to Export-led growth strategy  GDP multiplied by 10 in 40 years. Example followed by Taiwan, HK, Singapore, then by others • Explanations of the miracle: state intervention? MNF? • Common features: savings and investment rates / schooling / low inflation / openness / little external loans until the 90s

B) The weaknesses • Productivity remains low (growth is due more to the volume of factors of production than to technology) • Weak financial systems: insufficient regulation and control by central banks • « Crony capitalism » : opaque relations between businessmen and government (Thailand, Indonesia); financing of projects goes to non productive investment (housing bubble) • Legislative framework is lacking (no bankruptcy law)

C) The Asian crisis • Devaluation of the Thai Baht July 1997 by 15%. This was anticipated, and triggered a decline in for-ex reserves. The devaluation does not calm down the fears and speculation continues • Extension of the crisis to neighbour countries (all the region is weakened by a recession in Japan) • Dilemma: either let the moneys depreciate, or raise interest rates. All countries (except Malaysia) appeal to the IMF, which grants loans but imposes severe reforms. Output falls in 1998, but new start in 1999, with depreciations enhancing export rise and import decline • Further consequences: Russian crisis in 1998 +

End of the lesson • Any questions? • Exercise for next week