Overview

 

International capital movements can bringmajor gains both to the lending or investing countries and to the borrowingcountries, through intertemporal trade and through portfolio diversificationfor the lenders/investors. But international lending and borrowing sometimes isnot well-behaved—financial crises are recurrent. This chapter examines both thegains from well-behaved lending and borrowing and what we know aboutinternational financial crises.

 

We begin with the economic analysis ofinternational capital flows that focuses on the stock of wealth of twocountries and how that wealth can be lent or invested in the two countries.With no international lending, the country that has much wealth relative to itsdomestic investment opportunities will have a lower rate of return or interestrate. Freeing international capital flows permits the low-rate country to lendto the high-rate country. As the world shifts to an equilibrium with freecapital movements, both countries gain. As usual, however, within each countrythere are groups that gain and groups that lose from the international lending.

 

We can also use this analysis to show thateither nation could gain by imposing a small tax on the international capitalflows, because it could shift the pre-tax foreign interest rate in its favor.Either country could seek to impose a nationally optimal tax, but this workswell only if the other country does not impose a comparable tax.

 

International lending and borrowing oftenis well-behaved, but not always.  Thechapter focuses on financial crises in developing countries in the past threedecades. Following defaults in the 1930s, lending from industrialized countriesto developing countries was low for four decades. Such lending dramaticallyincreased in the 1970s for four reasons. First, oil-exporting countriesdeposited large amounts of petrodollars in banks following the increases in oilprices. Second, the banks did not see good prospects for lending this money toborrowers for capital spending in the industrialized countries. Third,developing countries resisted foreign direct investment from multinationalsbased in the industrialized countries, so increased capital flows to thedeveloping countries took the form of bank loans to these countries. Fourth,herd behavior among banks increased the total amount lent to developingcountries.

 

Crisis struck in 1982, when first Mexicoand then many other developing countries declared that they could not repay.The crisis was brought on by rising interest rates in theUnited States,which raised the cost of servicing the loans, and declining export earnings forthe debtor developing countries, as the industrialized countries endured a deeprecession. This debt crisis wore on through the 1980s. Beginning in 1989, theBrady Plan led to reductions in debt and conversion to bonds. By 1994, the1980s debt crisis was finally over.

 

Beginning in about 1990 lending todeveloping countries began to grow rapidly. LowU.S.interest rates led lenders andinvestors to seek out better returns elsewhere, and many developing countriesbecame more attractive as places to invest by shifting to more market-orientedpolicies. In addition, individual investors and fund managers began to viewdeveloping countries as emerging markets for financial investments.

 

Still, the 1990s were punctuated by aseries of financial crises. In late 1994 a large current account deficit, aweak banking system, and rapid growth in dollar-indexed Mexican government debt(tesobonos) led to a largedevaluation and depreciation of the Mexican peso and a financial crisis asforeign investors refused to buy new tesobonos.Contagion (the “tequila effect”) spread the crisis to other countries. A largerescue package offered mostly by theU.S.government and theInternational Monetary Fund (IMF) contained the crisis and the contagion.

 

The Asian crisis of 1997 hitThailandfirst and then spread toIndonesiaandSouth Korea, as well asMalaysiaand thePhilippines.The problems differed somewhat from one country to another, but one cause ofthe crisis was weak government regulation of banks, so that the banks borrowedlarge amounts of foreign currency, and then lent these funds to risky localborrowers. In addition, the growth of exports generally was declining for thesecountries, leading to some weakness in the current account.

 

Russiawas not much affected directly by the Asian crisis, but it had a large fiscaldeficit and the need for large borrowing by the government. By mid-1998 foreignlenders reduced their financing, and an IMF loan foundered when the Russiangovernment failed to enact changes in its fiscal policy. In the face of risingcapital flight, the Russian crisis hit, as the Russian government allowed theruble to depreciate and defaulted on much of its debt. With no rescue from theIMF, foreign lenders and investors suffered large losses. They reassessed therisk of lending to developing countries, and flows of capital to developingcountries declined for the year.

 

A small crisis hitBrazilin early1999, as the real was floated and immediately depreciated by a large amount. In2000,Turkeybegan to receive large capital inflows, based on its new program with the IMF.Foreign lenders pulled back later in the year, andTurkeywas forced to abandon itscrawling peg in early 2001.

 

Argentina pegged its peso to the U.S. dollarand succeeded in ending its hyperinflation in the early 1990s. However, thepeso experienced an increase in its real effective exchange rate value, and anextended recession began in 1998. The fiscal deficit widened, and the IMFstopped lending to it in late 2001. In early 2002 the government ended thepegged exchange rate and the peso lost three-fourths of its value relative tothe U.S. dollar. The banking system largely ceased to function and the economywent into a severe recession. After a few months delayArgentina’s crisis spread to neighboringcountries, especiallyUruguay.

 

Based on a survey of recent studies offinancial crises, the chapter discusses five reasons why they occur or are assevere as they are. The explanations have a common theme—once foreign lendersrealize that there is a problem, each has an incentive to stop lending and totry to get repaid as quickly as possible. If the borrower cannot immediatelyrepay, a crisis occurs. The first explanation is overlending and overborrowing.This can occur when the government borrows and guarantees private borrowing,and lenders view this as low risk. The box on “The Special Case of SovereignDebt” uses a benefit-cost analysis to show when a sovereign debtor woulddefault. The Asian crisis showed that overlending and overborrowing could occurwith private borrowers as well, especially if rising stock and land prices showhigh returns until the bubble bursts. The second explanation is exogenousshocks—for instance, a decline in export prices or a rise in foreign (oftenU.S.) interestrates—that make it more difficult for the borrower to service its debt. Thethird is exchange rate risk. This can be acute if private borrowers useliabilities denominated in foreign currency to fund assets denominated in localcurrency, betting that the exchange rate value of the local currency will notdecline (too much). If it does, borrowers attempt to hedge their risk exposure,putting further downward pressure on the exchange-rate value of the localcurrency, and then they may be forced to default if the local currency isdepreciated or devalued more, before they can fully hedge their risk exposures.The fourth explanation is a large increase in short-term debt to foreigners.The risk is that short-term debt denominated in foreign currency cannot readilybe rolled over or refinanced.

 

The first four explanations indicate why afinancial crisis can hit a country. The fifth explanation—contagion—indicateswhy a crisis in one country can spread to others. Contagion can be herdingbehavior by investors, perhaps fed partly by incomplete information on othercountries that might have problems similar to those of the crisis country.Contagion can also be based on a new recognition of real problems in othercountries, with the crisis in the first country serving as a “wake-up call.”

 

The new box “Insights and Parallels: ThisTime Is Not Different,” the fourth in the series on the global financial andeconomic crisis, explores the similarities between the causes of crises in developingcountries (as discussed in the text of the chapter) and the causes of theglobal crisis that began in 2007.

 

When a financial crisis hits a country, twomajor types of international efforts are used to help resolve it. First, arescue package, often led by an IMF lending facility, can be used to compensatetemporarily for the lack of private lending, to try to restore lenderconfidence, to try to limit contagion, and to induce the government of theborrowing country to improve its macroeconomic and other policies. While theMexican rescue in 1994 was very successful in helpingMexicoweatherthe crisis, the rescue packages for the Asian crisis countries were onlymoderately successful. A key question is whether the rescue packages increasemoral hazard, so that future financial crises become more likely becauselenders lend more freely if they expect to be rescued. The Mexican rescueprobably increased moral hazard, with mixed effects from the Asian rescues. Thelack of a rescue forRussiareduced moral hazard as lenders lost substantial amounts with no rescue packageimplemented. (Two boxes in the chapter are parts of the series on GlobalGovernance and focus on the IMF . The first box describes the IMF’s lendingactivities and its use of conditionality. The second presents the critique byJoseph Stiglitz of IMF lending policies and the IMF response.)

 

Second, debt restructuring (reschedulingand reduction) is used to create a more manageable stream of payments for debtservice. Restructuring can be difficult because an individual lender has anincentive to free ride, hoping that other creditors will restructure whiledemanding full repayment as quickly as possible for its own loans. The BradyPlan overcame the free rider problems to resolve the debt crisis of the 1980s.During the debt crises of the 1990s, it was relatively easy to restructure debtowed to foreign banks. A new problem was the great difficulty of restructuringbonds, because the legal terms of most bonds have given powers to small numbersof bondholders to resist restructuring. The current shift to bonds that includecollective action clauses should reduce this problem.

 

We now are paying more attention to findingways to reduce the likelihood or frequency of financial crises. Some proposalsfor improved practices in borrowing countries, including better macroeconomicpolicies, better disclosure of information and data, avoiding governmentshort-term borrowing denominated in foreign currencies, and better regulationof banks, enjoy widespread support. Other proposals are controversial, withexperts sometimes pointing in opposite directions. Developing countries shouldshift to relatively cleanly floating exchange rates, or they should move torigid currency fixes through currency boards. The IMF should have access togreater amounts of resources so it can help countries fight off unwarrantedfinancial attacks, or the IMF should be abolished to reduce moral hazard. Thechapter concludes by looking more closely at two proposals for reform, the needfor better bank regulation, and the controversial proposal that developingcountries should make greater use of capital controls to limit capital inflows,and especially to limit short-term borrowing.