The Surge in International Lending, 1974 -1982 Before World War I there was a large amount of international lending,

with Britain as the main creditor and the growing newly settled countries (the United States, Canada, Argentina, Australia) as the main borrowers. To a large extent this international lending fit the well behaved model as lending sought out high returns (although defaults were also common). During the 1920s, a large number of foreign governments issued foreign bonds, especially in New York, as the United States became a major creditor country. But in the 1930s, the depression led to massive defaults by developing countries, which frightened away lenders through the 1960s. Lending to developing countries remained very low for four decades. The oil shocks of the 1970s led to surge in private international lending to developing countries. Between 1970 and 1980, developing country debt outstanding increased almost eightfold, with debt rising from 10.6 percent of the countries national product in 1970 to 21.4 percent in 1980. The oil shocks quadrupled and then tripled the world price of oil, and these shocks caused recessions and high inflation in the industrialized countries. How did the shocks also revive the lending? Four forces combined to create the surge. First, the rich oil-exporting nations had a high short-run propensity to save out of their extra income. While their savings were piling up, they tended to invest them in liquid form, especially in bonds and bank deposits in the United States and other established financial centers. The major international private banks thereby gained large amounts of new funds to be lent to others borrowers. The banks had the problem of recycling or reinvesting the petrodollars. But where to lend? Second, there was widespread pessimism about the profitability of capital formation in industrialization countries. Real interest rates in many countries were unusually low. One promising area was investment in energy-saving equipment, but the development of these projects took time. For a time the banks expanded ability to lend was not absorbed by borrowers in the industrial countries, which encouraged banks to look elsewhere. Attention began to shift to developing countries, which had long been forced to offer higher rates of interest and dividends to attract even small amounts of private capital. Third, in developing countries, the 1970s was an era of peak resistance to foreign direct investment (FDI), in which the foreign investor, usually a multinational firm based in an industrialized country, keeps controlling ownership of foreign affiliated enterprises. Banks might have lent to multinational firms for additional FDI, but developing countries were generally hostile to FDI. Populist ideological currents and valid fears about political intrigues by multinational firms brought FDI down from 25 percent of net financial flows to developing countries in 1960 to less than 10 percent by 1980. To gain access to the higher returns offered in developing countries, banks had to lend outright to governments and companies in these countries. Fourth, herding behavior meant that the lending to developing countries acquired a momentum of its own space once it began to increase. Major banks aggressively sought lending opportunities , each

showing eagerness to lend before competing banks did. Much of the lending went to poorly planned projects in mismanaged economies. But everyone was doing it. The Debt crisis of 1982 In August 1982, Mexico declared that it was unable to service its large foreign debt. Dozens of other developing countries followed with announcements that they also could not repay their previous loans. Several factors explain why the crunch came in 1982. Interest rates had increased sharply in the United States, as the U.S. Federal Reserve shifted to a much tighter monetary policy to reduce U.S. inflation. The United States and other industrialized countries sank into a severe recession. Developing countries exports declined and commodity prices plummeted, while real interest rates remained high. The debtors ability to repay fell dramatically. At first the responses of the bank creditors depended on how much each bank had lent. Smaller banks (those holding small shares of all loans) headed for the exits and eliminated their exposure by selling off their loans or getting repaid. The larger banks could not extricate themselves without triggering a larger crisis, and they hoped that the problems were temporary. They rescheduled loan payments to establish repayment obligations in the future, and they loaned smaller amounts of new money to assist the debtors to grow so that repayment would be possible Bank loans, which were most of the private lending to developing countries in the early 1980s, declined some-what in 1983 and 1984. The longterm debt of developing countries nearly doubled between 1980 and 1985, the ratio of debt to national product rose from 21 percent in 1980 to 33 percent in 1985, and the share of export revenues that was committed to service the debt nearly doubled, to 24 percent. As large banks reassessed the prospects for developing country debtors, they concluded that it was imprudent to lend more. The net flows of bank loans to developing countries became small in 1985 and remained low until 1995. As the debt crisis wore on through the 1980s, it became clear that the debtor countries were suffering low economic growth and lack of access to international finance, but that this cost was not leading to repayments that would end the crisis. In response, U.S. Treasury officials crafted the Brady Plan (named after U.S. Treasury Secretary Nicholas Brady). Beginning in 1989, each debtor country could reach a deal in which its bank debt would be partially reduced, with most of the remaining loans repackaged as Brady bonds. By 1994, most of the bank debt had been reduced and converted into bonds. The debt crisis that began in 1982 was effectively over. The Resurgence of Capital Flows in the 1990s Beginning in about 1990, lending to and investing in developing countries began to increase again. Four forces converged to drive this new lending. First, the size and scope of the Brady Plan led investors to believe that the previous crisis was being resolved. As each debtor country agreed to a Brady deal, it was usually able to receive new private lending immediately. Second, low U.S. interest rates again led lenders to seek out higher returns through foreign investments. Third, the developing countries were becoming more attractive places to lend as governments reformed their policies. Governments were opening up opportunities for financing profitable new investments as they deregulated industries, privatized state-owned firms, and encouraged production for export with outward-oriented trade 2

policies. Fourth, individual investors, as well as the rapidly growing mutual funds and pension funds, were looking for new forms of portfolio investments that could raise returns and add risk diversification. Developing countries became the emerging markets for this portfolio investment. The rapidly growing flows on long-term investments into developing countries, as total net financial inflows increased every year from 1989 to 1997. The majority of this money went to a small number of developing countries viewed as the major emerging markets Mexico, Brazil, and Argentina in Latin America and China, Indonesia, Malaysia, South Korea and Thailand in Asia. The types of investments were different from those that drove the lending surge in the late 1970s. Foreign portfolio investors net purchases of stocks and bonds rose from almost nothing in 1990 to nearly one third of total net financial flows in 1996. Bank lending was less important, but even bank lending increased substantially from 1994 to 1997. It shows that developing country debt outstanding rose as a percentage of national product from 36 percent in 1990 to 40 percent in 1995, but that lower interest rates actually lowered the share of exports of goods and services that had to be devoted to debt service. The Mexican Crisis, 1994 1995 A series of crises punctured the generally strong flows of international lending to developing countries since 1990. The first of these struck Mexico in late 1994. Mexico received large capital inflows in the early 1990s, as investors sought high returns and were impressed with Mexicos economic reforms and its entry into the North American Free trade Area. But strains also arose. The real exchange rate value of the peso increased, because the government permitted only a slow nominal peso deprecation, while the Mexican inflation rate was higher than that of the United States, its main trading partner. The current account deficit increased to 6 percent of Mexicos GDP in 1993, although this was readily financed by the capital inflows. Mexicos banking system was rather weak, with inadequate bank supervision and regulation by the government. With the capital inflows adding funds to the Mexican banking system, bank lending grew rapidly, as did defaults on these loans. The year 1994was an election year with some turmoil, including an uprising in the Chiapas region and two political assassinations. The peso came under some downward pressure. The government used sterilized intervention to defend its exchange rate value, so its holdings of official international reserves fell. Mexicos fiscal policy was reasonable, with a modest government budget deficit. Still, the fiscal authorities made the change that became the center of the crisis, by altering the form of the government debt. Beginning in early 1994, the government replaced peso-dominated government debt with short-term dollar - indexed government debt called tesobonos. By the end of 1994, there were about $28 billion of tesobonos outstanding, most maturing in the first half of 1995.

The crisis was touched off by a large flight of capital, mostly by Mexican residents who feared currency devaluation and converted out of pesos. In December the currency was allowed to depreciate, but Mexican holdings of official reserves had declined to about $6 billion. The financial crisis arose as 3

investors refused to purchase new tesobonos to pay off those coming due, because it appeared that the government did not have the ability to make good on its dollar obligations. Each investor wanted to be paid off in dollars - a rush to the exit but what was rational for each investor individually was not necessarily rational for all of them collectively. The Mexican government might not be able to repay all of them within a short time period. As investors reassessed their investments in emerging markets, they pulled back on investments not only in Mexico but also in many other developing countries (the tequila effect). The U.S. government became worried about the political and economic effects of financial crisis in Mexico, and it arranged a large rescue package that permitted the Mexican government to borrow up to $ 50 billion, mostly from the U.S. government and the International Monetary Fund (IMF). The Mexican government did borrow about $ 27 billion, using the money to pay off the tesobonos as they matured and to replenish its official reserve buildings. The currency depreciation and the financial turmoil caused rapid and painful adjustments in Mexico. The Mexican economy went into a severe recession, and the current account deficit disappeared as imports decreased and exports increased. As the rescue took hold, the pure contagion that led investors to retreat from nearly all lending to developing countries calmed after the first quarter of 1995. The adverse tequila effect lingered for a smaller number of countries, as investors continued to pull out of Argentina, Brazil, and to lesser extents, Venezuela and the Philippines. Still, much of the Mexican financial crisis of 1994-1995 was resolved quickly. Overall capital flows to developing countries continued to increase in 1995 and 1996. The Asian Crisis, 1997 In the early and mid 1990s, foreign investors looked favorably on the rapidly growing developing countries of Southeast and East Asia. In these countries macroeconomic policies were solid. The governments had fiscal budgets with surpluses or small deficits; steady monetary policies kept inflation low, and trade policies were outward oriented. Most of the foreign debt was owed by private firms, not by the governments. A closer look showed a few problems. In Thailand and South Korea, much of the foreign borrowing was by banks and other financial institutions. Government regulation and supervision were weak. The banks took on significant exchange rate risk by borrowing dollars and yen and lending in local currencies. And the lending boom led to loans to riskier local borrowers and rising defaults on loans. In Indonesia, much of the foreign borrowing was by private nonfinancial firms, which took on the exchange rate risk directly. The external balance of the countries also showed some problems. The real exchange rate values of these countries currencies seemed to be somewhat overvalued, and the growth of exports slowed beginning in 1996. With the exception of Thailand, the current account deficits were not large. Thailands current account deficit rose to 8 percent of GDP in 1996. Still, the strong capital inflows provided financing for the deficits.

Crisis struck first in Thailand. Beginning in 1996, the expectation of declining exports led to large declines in Thai stock prices and real estate prices. The exchange rate value of the Thai baht came under downward pressure. By mid-1997, the pressures had become intense. Banks and other local firms that had borrowed dollars and yen without hedging rushed to sell baht to acquire foreign currency assets. The Thai government could not maintain its defense, and the baht was allowed to depreciate beginning in July 1997. Throughout the rest of 1997 the crisis spread to a number of other Asian countries, especially to Indonesia and South Korea, but also to Malaysia and the Philippines, as foreign investors lost confidence in local bank burrowers and the local stock markets, and as local borrowers scrambled to sell local currency to establish hedges against exchange rate risk. The exchange rate values of the currencies of Thailand, Indonesia, Korea, Malaysia, and the Philippines during the second half of 1997 declined by 4050 percent. In response, the IMF organized large rescue packages, with commitments to lend up to $ 17 billion to Thailand ($13 billion actually borrowed), up to $ 42 billion to Indonesia ($11 billion borrowed), and up to $58 billion to South Korea ($27 billion burrowed). As in Mexico, these large rescue packages and policy changes did contain the crises, though not without costs. The currency depreciations and the recessions did lead to improvements in the current account balance, largely through decreases in imports. However, these countries also went into severe multiyear recessions. The Brazilian Crisis , 1999 Brazil was among the countries hit hard by the fallout from the Russian crisis. In November 1998, the IMF organized a package that allowed the Brazilian government to borrow up to $41 billion ($18 billion actually borrowed), in an effort to allow Brazil to fight pressures pushing toward a crisis. Brazil had a large current account deficit, and the government was defending its crawling exchange rate with intervention and high domestic interest rates. However, the government failed to enact the fiscal reforms called for in the IMF loan, and capital outflows increased. In January 1999, the Brazilian government ended its pegged exchange rate, and the real depreciated. However, this situation did not escalate into a full crisis because the problems did not spread to the Brazilian banking system, which was sound and well regulated. By April 1999, Brazil and other developing countries were able to issue new bonds to foreign investors. More generally, the market prices of emerging market financial assets began to increase, although the net capital flows to developing countries remained lower than they had been in 1997.

Argentinas crisis, 2001 2002 In the late of 1980s, Argentinas economy was a mess, with hyperinflation of over 2,000 percent per year and a currency whose exchange value was in free fall. In a few years in the early 1990s everything changed, as it fixed its peso to the U.S. dollar using a currency board, reduced its inflation rate to almost 5

zero, and grew rapidly up to 1998. It also strengthened its banking system and established sound regulation and supervision. Foreign investors saw all this and they liked it foreign capital flowed into Argentina. Beginning in 1997 the peso experienced a real appreciation, first because the dollar strengthened against other currencies, and then because Brazils currency depreciated by a large amount in 1999. The international price competitiveness of Argentinas products declined and its current account deficit increased. Its fiscal situation had been a weak point all along, and the fiscal deficit increased as the economy went through years of recession beginning in 1998. Much of the government debt was denominated in foreign currencies and owed to foreign lenders and bondholders. In late 2000, Argentina reached agreement for a package of official loans of up to $ 40 billion, with $ 14 billion committed by the IMF. However, things did not improve, and the fiscal deficit remained a problem. Private capital inflows dried up. Rising interest rates in Argentina made the recession worse. In September 2001 the IMF made an unusually large disbursement of $6 billion to Argentina, but it was to be the last. The IMF refused to make additional loans under the rescue package because the government had not met the conditions set by the Fund for improvements in government policies. The Argentinean people began to fear for the continuation of the fixed exchange rate and the soundness of the banking system. In response to depositor runs on banks, the government closed the banks in November. When the banks reopened in December, withdrawals were severely limited. Angry protest spawned looting and rioting, with 23 deaths. The countrys president resigned, and Argentina then had for new presidents in two weeks. In early 2002 the government surrendered the fixed exchange rate, and the peso lost about 75 percent of its value in the first six months of the year. The government defaulted on about $ 140 billion of its debt, much of it owed to foreigners, the largest default ever. In addition, the peso depreciation caused huge losses in the banks because of some mismatch of dollar liabilities and dollar assets, and liabilities into pesos. A number of banks closed, and the banking system was nearly nonfunctional. During 2002 real GDP declined by 11 percent, a huge recession after the economy had already endured several previous years of recession. At first it appeared that Argentinas collapse would have few effects on other developing countries, since it has been widely expected. But after a few months Argentinas problems did spread to its neighbors, especially Uruguay. Uruguay relied on Argentina for tourism and banking business. The tourism dried up, and Argentinean withdrawals from their Uruguayan accounts increased. After its holdings of official reserves plummeted defending Uruguays crawling pegged exchange rate, the Uruguay government floated its currency in June, within two weeks the currency had fallen by half. In August Uruguay received an IMF rescue package and used it to stabilize its financial situation. Still, it suffered a severe recession, with real GDP declining by over 10 percent during the year. 9Source: Thomas Pugel, International Economics, Tata McGraw Hill