1

Economics seminar

ECONOMIC

POLICIES

IN TIMES
ECONOMIC

OF

CRISES

Professor Grard GRELLET

Universit Pars I - Sorbonne

Chapter 1 : The macroeconomic framework

Chapter II : Monetary policy
Chapter III : Balance of payments policy and exchange rates management
Chapter IV: Debt policy
Chapter V : Financial crises
Chapter VI : East Asian financial crises
Chapter VII : Latin Americas financial crises

C H APT E R

T HE

M A C R E C O NO M I C

FR AM E W O R K

I 1 ) The macroeconomic framework

In order to study economic policy we shall begin by setting out the basic
framework of macroeconomic policy.
Ex post aggregate demand (D) is equal to aggregate supply (S).
Aggregate demand is the sum of :
-

Final consumption expenditure (C)

Investment expenditure (I)

Government expenditure (G)

Exports ( X)

Increase in stocks ( d ST)

Aggregate supply is equal to :

-

Gross domestic Product ( GDP)

Imports (M)

Depletion in stocks ( - d ST)

Thus ex post we have :

GDP + M + d ST = C + I + G d ST + X
C + I + G is referred as domestic absorption (A)
X M is the balance of trade

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Thus if we assume for the sake of simplicity that there is no change in
stocks and that GDP is equal to domestic income:
GDP A = X M
Or
(GDP C) I = S I = X M
The balance of trade is equal to the difference between domestic income and
absorption.
If M X > 0 the balance of trade has to funded

has to funded :

M X = Net transfers payments ( including remittances) + additionnal

borrowing + depletion of international reserves
Where does a balance of trade imbalance come from ?
M X = I S = (IP SP) + ( IG SG)
Where :
IP and SP are respectively prvate investment and prvate saving
IG and SG public investment and saving.
The imbalance between IP and SP may come from :
-

Credit by commercial banks in excess of deposits

Dehoarding in excess of hoarding. This is for example the case if, in

anticipation of inflation, cash holders reduce their cash balance.

6
The imbalance between IG and SG comes from a budgetary imbalance
(dficit) which may be funded by :
-

An ex nihilo creation of money

An increase of public indebtness

I - 2 ) Data in International Financial Statistics

The national accounts lines shown in the country tables (www.imf.org) are as
follows:
Household Consumption Expenditure (line 96f) consists of the
expenditure incurred by resident households and resident NPISHs on
individual consumption goods and services
GovernmentConsumption Expenditure (line 91f) ) consists of expenditure
incurred by general government on both individual-consumption goods and
services and collective-consumption services.
Gross Fixed Capital Formation (line 93e) is measured by the total
value of a producers acquisitions, less disposals, of fixed assets during
the accounting period, plus certain additions to the value of
nonproduced assets (such as subsoil assets or major improvements in
the quantity, quality, or productivity of land).
Changes in Inventories (line 93i) consist of changes in (1) stocks
of outputs that are still held by the units that produced them before
the outputs are further processed, sold, delivered to other units, or
used in other ways and (2) stocks of products acquired from other
units that are intended to be used for intermediate consumption or for
resale without further processing.

Exports of Goods and Services (line90c), and Imports of Goods and Services
(line 98c) consist of sales, barter,gifts, or grants of goods and services from
residents to nonresidents.

Imports of Goods and Services (line 98c) consist of purchases, barter,

or receipts of gifts or grants of goods and services by residents from
nonresidents.
Gross Domestic Product (GDP) (line 99b) is the sum of
consumption expenditure (of households and general
government), gross fixed capital formation, changes in inventories, and
exports of goods and services, less the value of imports of goods and
services.
Net Primary Income from Abroad (line 98.n) is the difference
between the total values of the primary incomes receivable from, and
payable to, nonresidents.
Gross National Income (GNI) (line 99a) is derived by adding Net
Primary Income from Abroad (line 98.n) to GDP.
Gross National Disposable Income (GNDI) (line 99i) is derived by adding Net
CurrentTransfers from Abroad (line 98t) to GNI.

I 3 ) Idiosyncresies of development macroeconomics : ten stylised

facts

1)

Developing countries tend to be open and have little control over the

prices of goods they export and import because of their small share in the
world economy.Terms of trade are exogeneous. Since prices of primary
commodities tend to fluctate sharply this accounts for a significant source
of macroeconomic instability
2)

There is a large selfsufficient sector in agriculture and in urban

informal activities which is largely deconnected with the modern sector

3)

Private economic behaviour has to take into account credit and foreign

exchange rationing. This affects investment, assets demand and export

supply.
4)

Developing countries tend to be capital importers. The risk of non

servicing the foreign debt may be high. The servicing of external debt is
therefore a central policy issue
5)

Production relies heavily on imported intermediate goods

(approximatively half of all developing countries imports). In the presence

of foreign exchange rationing , the avaibility of foreign exchange may thus
have a direct effect on the short run supply curve

6)

The labor market is segmented between a government regulated

market and an informal market with a low degree of mobility between these
sectors.
7)

There is a high degree of real wage flexibility. Only a few countries

(Brazil , Chile) have an economy wide wage indexation.

8)

Financial institutions tend to be rudimentary. Financial markets are

dominated by commercial banks which are heavily regulated, subjected to

high reserve and liquidity ratios. Credit rationing tends to be legally
imposed rather endogeneously generated by information asymetries.
I 3 ) Three kinds of economic crises : stylised facts
I 3 1) External demand shocks in an export dependant economy:
M>X
Demand shocks refer to the vulnerability of small open economies to
recessions in the world economy or in primary commodity markets.
Falling exports should result in an equivalent reduction of imports. But
since imports are essential both for consumption and investment, the
recessionary impact of falling exports does not always result in an
equivalent reduction in imports. This causes the current account of the
balance of payments to worsen, creating both internal and external
imbalances.
I 3 2) Internal imbalances
Falling exports generate falling budgetary revenues. Since budgetary
expenditures are mostly incompressible this entails a budget deficit. This
deficit could be covered by printing money or by increasing the public debt.
Each of these sources of deficit financing can cause a particular kind of
macroeconomic problem.
-

Money creation will lead to inflation. Inflation will worsen the budget

deficit because public expenditure keeps pace with inflation while budget
revenues do not ( the so-called Tanzi effect). Printing more money may
appear necessary but will worsen the inflationary spiral.

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-

Domestic borrowing ( if possible) will lead to a credit squeeze through

higher interest rates or through the crowding out of prvate investment and
consumption ( i.e. financial repression)
I 3 3 ) External imbalances
Under a fixed rates regime the current account deficit has to be covered
either by external borrowing or by cutting imports. External borrowing to
cover a current balance of payment deficit is not usually possible. Cutting
imports will reduce future production and exports.
Under a flexible exchange rate regime the current account deficit will
depreciate the domestic currency against foreign currencies. This will create
inflati
onary tensions. If wages are indexed this may trigger an inflationary spiral.

Debt crisis ( see chapter IV)

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C H APT E R I I

M O N E TAR Y PO LI C Y

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II 1) Institutions

The central bank

Three kinds of situation :
a.

fully fledged central bank :

dependent : creates money on request by the government ( Morocco,

Algeria, China)
-

independent : follows an independent monetary policy on the rate of

exchange, the rate of interest, the credit policy as lender of last resort
b.

Supranational central bank

zone franc

c.

Currency board:

Money is created only in compensation for foreign currencies at a fixed rate

(Argentina 1991 2001)
Building monetary institutions
If the monetary authorities have little credibility in terms of commitment to
price stability, monetary policy will be ineffective. Any expansionary
monetary policy will lead to an immediate rise in the rate of interest, in the
depletion of cash balances and very quickly in the price level.
Building monetary credibility is a difficult task particularly if the monetary
authorities have a history of poor support for the price stability goal. One

13
way to express the commitment to price stability is to make laws that assure
that the central bank is independant from the budgetary authorities, that its
director and board are independent from political pressures and that they are
judged according to their commitment to fight inflation. However law is not
sufficient. According to the Argentine law the central bank was highly
independent. However it did not stop the Argentine government to force
the president of the central bank to resign and replace it with a more
obedient president.
II 2 ) DATA

Monetary authorities data (section 10)

Data on monetary authorities measure the stock of reserve money comprising

currency in circulation, deposits of the deposit money banks, and deposits of
other residents, apart from the central government, with the monetary
authorities.

Assets
Major aggregates of the accounts on the asset side are foreign
assets (line 11) and domestic assets (line 12). Domestic assets are
broken down into Claims on Central Government (line 12a), Claims
on Deposit Money Banks (line 12e), and, if sizable, Claims on State
and Local Governments (line 12b); Claims on Nonfinancial Public
Enterprises (line 12c); Claims on the Private Sector (line 12d); Claims
on Other Banking Institutions (line 12f), and Claims on Nonbank
Financial Institutions (line 12g).
Liabilities
The principal liabilities of monetary authorities consist of Reserve
Money (line 14); Other Liabilities to Deposit Money Banks (line 14n),

14
comprising liabilities of the central bank to deposit money banks that
are excluded from Reserve Money; Liabilities of the Central Bank:
Securities (line 16ac); Foreign Liabilities (line 16c); Central Government
Deposits (line 16d); and Capital Accounts (line 17a).

Monetary survey

Monetary authorities and deposit money banks data are

consolidated into a monetary survey (section 30). The survey
measures the stock of narrow Money (line 34), comprising
transferable deposits and currency outside deposit money banks, and
the Quasi-Money (line 35) liabilities of these institutions, comprising
time, savings, and foreign currency deposits.
Standard relationships between the monetary survey lines and the
component lines in sections 10 and 20 are as follows:
-

Foreign Assets (Net) (line 31n) equals the sum of foreign asset

lines 11 and 21, less the sum of foreign liability lines 16c and 26c.
-

Claims on Central Government (Net) (line 32an) equals claims on

central government (the sum of lines 12a and 22a), less central
government deposits (the sum of lines 16d and 26d), plus, where
applicable, the counterpart entries of lines 24..i and 24..r (private sector
demand deposits with the postal checking system and with the
Treasury).
-

Claims on State and Local Governments (line 32b) equals the sum

of lines 12b and 22b.

-

Claims on Nonfinancial Public Enterprises (line 32c) equals the

sum of lines 12c and 22c.

-

Claims on Private Sector (line 32d) equals the sum of lines 12d

and 22d.

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Claims on Other Banking Institutions (line 32f) equals the sum of

lines 12f and 22f.

-

Claims on Nonbank Financial Institutions (line 32g) equals the

sum of lines 12g and 22g.

-

Domestic Credit (line 32) is the sum of lines 32an, 32b, 32c, 32d,

32f, and 32g even when, owing to their small size, data for lines 32b,
32c, 32f, and 32g are not published separately. Thus, the data for line
32 may be larger than the sum of its published components.
-

Money (line 34) equals the sum of currency outside deposit

money banks (line 14a) and demand deposits other than those of the
central government (lines 14d, 14e, 14f, 14g, and 24) plus, where
applicable, lines 24..i and 24..r.
-

Quasi-Money (line 35) equals the sum of lines 15 and 25,

comprising time, savings, and foreign currency deposits of resident

sectors other than central government.
The data in line 34 are frequently referred to as M1, while the sum
of lines 34 and 35 gives a broader measure of money similar to that
which is frequently called M2.
Money Market Instruments (line 36aa) equals the sum of lines
16aa and 26aa.
Bonds (line 36ab) equals the sum of lines 16ab and 26ab.
Liabilities of Central Bank: Securities (line 36ac) equals the
outstanding stock of securities issued by the monetary authorities (line
16ac) less the holdings of these securities by deposit money banks
(line 20c).
Restricted Deposits (line 36b) equals the sum of lines 16b and
26b.

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Long-Term Foreign Liabilities (line 36cl) equals the sum of lines
16cl and 26cl.
Counterpart Funds (line 36e) equals the sum of lines 16e and 26e.
Central Government Lending Funds (line 36f) equals the sum of
lines 16f and 26f.
Liabilities to Other Banking Institutions (line 36i) is equal to line
26i.
Liabilities to Nonbank Financial Institutions (line 36j) is equal to
line 26j.
Capital Accounts (line 37a) equals the sum of lines 17a and 27a.

II 3 ) Developing countries monetary idiosyncresies

Money and financial markets are underdeveloped

-

credit for household consumption is often non existent since it cannot

be backed by mortgages
-

credit for business is less developed than in industrial countries as the

risk is higher. Firms have recourse to self financing. Therefore the response
to changes in interest rates or credit availability is limited.
-

Domestic financial markets are small compared with outside markets.

The domestic rate of interest is determined by the US rate of interest on

Treasury bonds with a risk premium.

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Fiscal position and money balances
If a large proportion of the fiscal deficit is financed by borrowing from the
central bank the fiscal position has a large impact on the money balances.
Similarly if the public debt is a large proportion of the GDP, a small change
in the rate of interest may have a large impact on the budget.
The central bank as lender of last resort
In developing countries the central bank may has four interlinked goals:
-

To fix the rate its own currency on the foreign exchange market

To set the rate of interest

To fund the budget

To fix the rate of inflation by regulating the quantity of money

In the most developed countries these two last goals have dropped since in
an open economy it is technically difficult to regulate the quantity of money
and since budgets are supposed to be balanced by emitting bonds not by
printing money. After the 1997 Asian crisis most developing countries have
abandoned a fixed peg , the rate of exchange being fixed by the market.
Thus the primary role of to-day central banks is to set the set of money - the
interest rate which indirectly monitors the rate of inflation, the debt
service and the flows of cross-border financial funds.
By distributing overnight central bank cash in return for loans of
commercial banksassets , central banks set the overnight rate of interest.
Other rates of interest depend on this overnight risk free rate but also on
the riskiness of lending. Central banks cannot control these directly.
In a crisis central banks have enormous firepower to drown financial
institutions in cash but they face two risks.

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Firstly they send the overnight interest rate tumbling because banks may
have too much cash and they try to lend it out which can cause inflation and
an outflow of international short term capital. Secondly they send the signal
that they are always ready to bail out banks and thus encourage riskier
practices in future.
In developed economies the central bank issues credit in order to bail out the
banking system but the extra liquidity is expected to be soaked up later on
by open market operations so this extra liquidity has no consequences on the
rate of inflation. In contrast in emerging countries with no or little open
market operations the central bank lending to the banks will create an
inflationary pressure and an exchange rate depreciation which may lead to
major balance sheets inbalances.

I 4 ) Monetary policies controversies

Neoclassical theory and practice of monetary policy
Neoclassical economists consider that monetary policy is relatively
ineffective as long as the economy is working close to full employment so
that any increase in aggregate nominal demand can only push up prices.
There is however an important exception of the neutrality of monetary
policy: inflation and hyperinflation. Inflation and hyperinflation blur the
economic information as it distorts relative prices and gives a premium on
speculation.
The conservative monetary policy advocates a simple rule which consists of
expanding the money supply at a constant rate which should correspond to
the rate of growth of monetary transactions in order that , according to the
Fisher equation, the rate of inflation should be nil. However the demand
function for cash balances and the rate of growth of the money supply are

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hard to predict in an open economy, especially under a floating exchange
rate.
The Keynesian perspective
For Keynesian economists monetary policy could be an effective tool in
macroeconomic management as it can lower the nominal interest rate which
could be disconnected from the real rate of return. The differential between
the nominal rate of interest and the expected rate of profitability explains the
level of investment.

Heterodox perspective
1)

The level of economic activity is determined by credit not by money

supply so the banking system appears more important than the central bank.
2)

Changes of the rate of interest represents a distribution from creditors

to debtors. As the marginal propensity to consume and invest is not between

the two groups the same, this will have some consequences on aggregate
demand.
3)

Changes in the rate of interest have an impact on the value of real

assets (and particularly on real estate values) and consequently on the

decision to consume and invest.

Fighting inflation and hyperinflation

Causes of inflation

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1)

Until the 90s many governments ( except the ones belonging to the

zone franc) had recourse to monetary inflation to finance fiscal deficits,

particularly in Latin America. In many African and Latin American
countries the tax base was limited so budget income came mainly from
foreign trade taxes which fluctuate according to the price of export
commodities. Budget expenditures ( army, police, public administration)
on the other hand were largely pre-determined. In case of a large deficit the
easiest solution was to have recourse to monetary financing by advances of
the central bank to the Treasury.
2)

The liberalization of the capital account increased short term,

speculative, capital movements. These inflows of foreign currencies had to

be converted in domestic currency and thus increased the monetary stock.
3)

Domestic financial system were largely autonomous and improperly

managed by the central bank.

Reasons for fighting inflation
1)

The main reason for fighting inflation is that it creates distortions in

relative prices and incomes. It is not income distribution and economic

incentives neutral. More particularly inflation reduces the visibility of
investment and gives a premium on speculative investment on productive
investment. In case of hyperinflation agents will prefer to detain foreign
currencies, gold or real estate, rather than government bonds or productive
investment but, as precautionary savings increase, consumption is sluggish
or declining and the rate of return on non speculative investment falls.

2)

The second reason is that inflation creates distortions in income

distribution as it gives a premium on speculative earnings and on indexed

incomes over non indexed ones.

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3)

The third reason is that inflation changes anticipations and particularly

anticipations of the future rate of inflation. If agents have endured in the

past high level of inflation they will expect inflation to continue and will not
detain cash balances so the velocity of money will increase. This explains
why hyperinflation can be carried on without any significant increase in the
quantity of money.
4)

The fourth reason is the so called Tanzi effect : as tax incomes are

calculated on past incomes, inflation will reduce real budgetary income and
increase the budgetary deficit. If this deficit is financed by monetary
creation this will create a self sustained inflationary spiral.
5)

Finally inflation will end in a devaluation which is inflationary,

particularly if a large part of the population can index its income. This will
create a self sustained devaluation inflation devaluation spiral.

What kind of policy against inflation ?

1)

In cases of mild or moderate inflation :

reduce the fiscal deficit financed by advances of the central bank

put a ceiling on credit except on sectors considered as bottlenecks

freeze the short term , speculative capital flows

The negative of these measures is that they will increase the rate of interest
in the short term.
The problem is the coordination on the one hand between monetary
authorities and fiscal authorities and on the other hand between internal and
external balances. There is a risk of a perpetual over or undershooting which
calls for a close coordination between fiscal and monetary authorities.

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2)

In case of hyperinflation

These measure appear insufficient in case of hyperinflation. Authorities

need a psychological shock such as the creation of a currency board
domestic currency will only be created in compensation of an increase in
foreign reserves- or such as the substitution of the national currency by the
US $.

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CHAPTER III

EXCHANGE RATE MANAGEMENT

AND
BALANCE OF PAYMENTS POLICY

III 1 ) Data : The balance of payments

Current Account (line 78ald) is the sum of the balance on

24
goods, services and income (line 78aid), plus current transfers.:
credit (line 78ajd), plus current transfers: debit (line 78akd) (i.e., line
78aid, plus line 78ajd, plus line 78akd).
Goods: Exports f.o.b. (line 78aad) and Goods: Imports f.o.b. (line
78abd) are both measured on the "free-on-board (f.o.b.) basisthat
is, by the value of the goods at the border of the exporting economy.
For imports, this excludes the cost of freight and insurance incurred
beyond the border of the exporting economy. The goods item covers
general merchandise, goods for processing, repairs on goods, goods
procured in ports by carriers, and nonmonetary gold.
Trade Balance (line 78acd) is the balance of exports f.o.b. and
imports f.o.b. (line 78aad plus line 78abd). A positive trade balance
shows that merchandise exports are larger than merchandise imports,
whereas a negative trade balance shows that merchandise imports are
larger than merchandise exports.
Services: Credit (line 78add) and Services: Debit (line 78aed)
comprise services in transportation, travel, communication,
construction, insurance, finance, computer and information, royalties
and license fees, other business, personal, cultural and recreational, and
government.
Balance on Goods and Services (line 78afd) is the sum of the
balance on goods (line 78acd), plus services: credit (line 78add), plus
services: debit (line 78aed) (i.e., line 78acd, plus line 78add, plus line
78aed).

Income: Credit (line 78agd) and Income: Debit (line 78ahd)

comprise (1) investment income (consisting of direct investment
income, portfolio investment income, and other investment income),
and (2) compensation of employees.

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Balance on Goods, Services and Income (line 78aid) is the sum of the balance on
goods and services (line 78afd), plus income: credit (line 78agd), plus income:
debit (line 78ahd) (i.e., line 78afd, plus line 78agd, plus line 78ahd).
Current Transfers.: Credit (line 78ajd) comprise all current
transfers received by the reporting economy, except those made to the
economy to finance its overall balance (see line 78cbd description
below); therefore, the label n.i.e. The latter are included in
Exceptional Financing (line 79ded) (see below).
Current transferscomprise (1) general government transfers and (2) other sector
transfers, including workers remittances.Debit (line 78akd) comprise all current
transfers paid by the reporting economy.
Capital Account(line 78bcd) is the balance on the capital
account (capital account: credit, plus capital account: debit).
Capital account: credit (line 78bad) covers (1) transfers linked to
the acquisition of a fixed asset and (2) the disposal of nonproduced,
nonfinancial assets. It does not include debt forgiveness, which is
classified under Exceptional Financing. Capital account: debit (line
78bbd) covers (1) transfers linked to the disposal of fixed assets, and (2)
acquisition of nonproduced, nonfinancial assets.
Financial Account (line 78bjd) is the net sum of direct
investment (line 78bdd plus line 78bed), portfolio investment (line
78bfd plus line 78bgd), financial derivatives (line 78bwd plus line
78bxd), and other investment (line 78bhd plus line 78bid).
Direct Investment Abroad (line 78bdd) and Direct Investment in
Rep. Econ., n.i.e. (Direct Investment in the Reporting Economy, n.i.e.)
(line 78bed) represent the flows of direct investment capital out of the
reporting economy and those into the reporting economy,
respectively. Direct investment includes equity capital, reinvested
earnings, other capital, and financial derivatives associated with various
intercompany transactions between affiliated enterprises. Excluded are
flows of direct investment capital into the reporting economy for
exceptional financing, such as debt-for-equity swaps. Direct

26
investment abroad is usually shown with a negative figure, reflecting
an increase in net outward investment by residents, with a
corresponding net payment outflow from the reporting economy.
Direct investment in the reporting economy is generally shown with a
positive figure, reflecting an increase in net inward investment by
nonresidents, with a corresponding net payment inflow into the
reporting economy.
Portfolio Investment Assets (line 78bfd) and Portfolio Investment Liabilities (line
78bgd) include transactions with nonresidents in financial securities of any
maturity (such as corporate securities, bonds, notes, and money market
instruments) other than those included in direct investment, exceptional financing,
and reserve assets
Equity Securities Assets (line 78bkd) and Equity Securities
Liabilities (line 78bmd) include shares, stocks and participation that usually denote
ownership of equity.
Debt Securities Assets (line 78bld) and Debt Securities Liabilities
(line 78bnd) cover (1) bonds, debentures, notes, etc., and (2) money
market or negotiable debt instruments.

Financial Derivatives Assets (line 78bwd) and Financial

Derivatives Liabilities (line 78bxd) cover financial instruments that are
linked to other specific financial instruments, indicators, or
commodities, and through which specific financial risks (such as
interest rate risk, foreign exchange risk, equity and commodity price
risks, credit risk, etc.) can, in their own right, be traded in financial markets.
Other Investment Assets (line 78bhd) and Other Investment
Liabilities (line 78bid) include all financial transactions not
covered in direct investment, portfolio investment, financial
derivatives, or reserve assets. Major categories are transactions in
currency and deposits, loans, and trade credits.
Net Errors and Omissions (line 78cad) is a residual category

27
needed to ensure that all debit and credit entries in the balance of
payments statement sum to zero. It reflects statistical inconsistencies in
the recording of the credit and debit entries. In the IFS presentation, net
errors and omissions is equal to, and opposite in sign to, the total value
of the following items: the current account balance (line 78ald), the
capital account balance (line 78bcd), the financial account balance (line
78bjd), and reserves and reserve related items (line 79dad). The item is
intended as an offset to the overstatement or understatement of the
recorded components. Thus, if the balance of those components is a
credit, the item for net errors and omissions will be shown as a debit
of equal value, and vice versa.
Overall Balance (line 78cbd) is the sum of the balances on the
current account (line 78ald), the capital account (line 78bcd), the
financial account (line 78bjd), and net errors and omissions (line 78cad)
(i.e., line 78ald, plus line 78bcd, plus line 78bjd, plus line 78cad).
Reserves and Related Items (line 79dad) is the sum of transactions
in reserve assets (line 79dbd), exceptional financing (line 79ded), and
use of Fund credit and loans (line 78dcd) (i.e., line 79dbd, plus line
79ded, plus line 79dcd).
Reserve Assets (line 79dbd) consists of external assets readily
available to and controlled by monetary authorities primarily for direct
financing of payments imbalances and for indirect regulating of the
magnitude of such imbalances through exchange market intervention.
Reserve assets comprise monetary gold, special drawing rights, reserve
position in the Fund, foreign exchange assets (consisting of currency
and deposits and securities), and other claims.
Use of Fund Credit and Loans (line 79dcd) includes purchases and
repurchases in the credit tranches of the IMF's General Resource
Account, and net borrowings under the Structural Adjustment Facility
(SAF), the Poverty Reduction and Growth Facility (PRGF), which was
previously named the Enhanced Structural Adjustment Facility (ESAF),
and the Trust Fund.
Exceptional Financing (line 79ded) includes any other transactions

28
undertaken by the authorities to finance the "overall balance," as an
alternative to, or in conjunction with, the use of reserve assets and the
use of IMF credit and loans from the Fund.

III 2 ) Fixed versus flexible exchange rates

How is the foreign account balanced ?
Fixed rates of exchange were the rule during the Bretton Woods period
which ended in 1971.
Theoritically we have two kinds of situation :
1)

Fixed exchange rates

There is a fixed rate of exchange between the domestic currency and a

foreign currency ( $ or ) or a basket of foreign currencies. This regime is
often called hard peg. This is the case of monetary unions ( zone CFA) ,
currency boards and dollarization experiences.
In the case of a monetary union the overall balance of the external account
is managed by a monetary union central bank ( BCEAO and BEAC in the
zone franc). In order to avoid deficits the rate of increase of the monetary
supply is strictly monitored.
In the case of a currency board the central bank fixes a conversion rate
between the domestic currency and the dollar and provides full
convertibility on demand. This assumes that the currency board has always
enough international reserves to do so.
Full dollarization entails eliminating the domestic currency altogether and
replacing it by a foreign currency like the US $ (Panama) or the euro
(Monaco). In that case the government has no control on monetary policy.

29

Under a fixed rate of exchange regime the balance of the current account is
strictly equal to the surplus of the global supply over the global demand
(see chapter 1). Under some assumptions (no stocks , no hoarding , no
dehoarding) the imbalance between global demand and supply is only
possible by an imbalance of an equal amount between supply and demand
of money and finance.
More precisely if it is negative this imbalance has to be financed by:
-

an increase in indebtness either in foreign capital markets or by

borrowing to other central banks

-

by drawing on foreign reserves

by creating domestic money and selling it on the market to get

foreign currencies. Under fixed exchange rates this would suppose that the
market is ready to absorb an increase of the stock of domestic money at the
same price which is practically never the case. The US case is an exception
since there is a demand for dollars as a means of exchange and as central
banks reserves.

2)

Floating exchange rates

A floating exchange rates regime covers several cases as a country may

pursue different monetary policy strategies such as targeting the money
supply or an undervalued exchange rate in terms of purchasing power
parities ( this is the case of some tourism based economies). It can come
under a wide variety of arrangements such as soft peg ( the monetary
authorities intervene according to a policy target), crawling band ( the

30
monetary authorities intervene only at the floor and ceiling of the band) or
free floating (the monetary authorities do not intervene).
The targeted rate of exchange regime is often called soft peg. It depends
on the ultimate aims of the domestic policy : inflation targeting, boosting the
exports revenues, monitoring the external debt, fixing the domestic interest
rate...However if the targeted rate of exchange is not equal in the long run to
the equilibrium rate of exchange on the foreign currencies market the
country may accumulate foreign currencies reserves or have to borrow
foreign currencies to sustain the rate of exchange.
Usually the central bank is reluctant to let the exchange rate float freely on a
day to day basis so there is some kind of intervention in order to avoid large
speculative swings (particularly is the foreign currency market is very
narrow as it is the case of small countries like Gambia) though the
monetary authorities do not act against the trend.

3 ) What the theory and experience say on choosing an exchange rate

regime ?
The case for a fixed exchange rate regime
If the economy experiences a nominal shock that is a monetary imbalance
that causes inflation a fixed exchange rate regime should be preferred
because under a flexible change regime the inflation will translate into a
depreciation of the rate of exchange that would fuel further inflationary
pressures.
There are some other advantages of a fixed exchange rate:

31
-

it may promote foreign trade and economic integration ( as in

EEC or NAFTA)
-

it reduces the exchange risk component of borrowed capital thus

lowering the cost of capital even if there is still the risk of government or
private sector default : after the dollarization of the Ecuadorian economy in
January 2000 domestic interest rates remained considerably higher than US
interest rates in expectation of Ecuador sovereign bonds default (which
happened in August 2000)
The danger of a fixed exchange peg is that it can lock the economy into a
misaligned exchange rate which could be defined as an exchange rate
significantly different from the one fundamentals would dictate. The
problem is of course how to define ex ante these fundamentals ( in particular
these fundamentals may not be the same in the short term or in the long
term)
Moreover a fixed exchange rate system requires substantial international
reserves which have a high opportunity cost ( they are usually invested in
US Treasury bonds) though large emerging market economies such as Brazil
have large international reserves ( a country with large international reserves
is less likely to be under a massive speculative attack).

The case for a flexible exchange rate regime

If the economy experiences a real shock for example a shift in terms of
trade the exchange rate flexibility should be preferred since it will
translate into relative domestic prices and give incentives to make the
necessary production adjustments ( like increasing the profitability of
exports relatively to non export commodities).
The move from fixed to floating exchange rates makes the economy more
resilient to external shocks as an outflow of funds can now be

32
accommodated by falling exchange rates. However floating has its
negatives:
-

it increases indirectly the money supply on the extend that the

banks have foreign reserves which are re-evaluated ( in that case the central
bank should freeze the increase supply of money by imposing reserve
requirements to the banking sector or by soaking excess liquidities on the
open market)
-

it weakens the budget by raising the debt service

liability dollarization makes a freely floating exchange rate

difficult to sustain. A large devaluation raises the value of foreign

denominated debt and creates imbalances in the firms and financial
intermediaries balance sheets which could lead to a full- fledged financial
crisis.
Finally the decision to let the currency float during the crisis must be
predicated on the commitment of the international financial community to
dampen the overshooting of the nominal exchange rate in order to avert a
depreciation inflation spiral. This requires some coordination of the
interventions of the central banks which could only be fulfilled by the IMF.
Note that assuming that there is an overshooting is assuming that there is
an equilibrium rate of the nominal rate of exchange which of course raises
a Pandora box of theoretical problems ( such as : on which time table the
equilibrium rate of the nominal rate of exchange is defined ?)

III 3 ) The case for a weak exchange rate policy

Many development countries and particularly Asian countries such as
China or Vietnam - tend to look favourably on weak exchange rates policy

33
since it increases the attractiveness of exporting by making the country more
competitive and by helping domestic industries that compete with imports.
Directly or indirectly production for exports spill over into increased income
in all sectors.
An undervalued currency triggers a balance of payments surplus and set off
either an inflationary spiral or a dramatic increase in foreign currencies
denominated reserves ( China )

Inflationnary consequences of an undervalued exchange rate

-

an increase in the quantity of money created as a counterpart of

foreign currencies deposited at the central bank could set off an inflationary
spiral , depending on the extend of indexation.
To keep a competitive edge the central bank could reduce the quantity of
money through an open market policy but this would reduce the credit to its
exporters.
- the undervaluation changes the value of the countrys and firms overall
balance sheets:
-

it undervalues the domestic assets which may appear to be an easy

prey for foreign investors;

-

it overvalues the foreign debt and weakens domestic companies if

they borrow in the international capital market.

Eventually we should compare the gain in competitiveness with the overcost
of borrowing in foreign capital markets : in Thaland exporters gain more
from an undervalued baht than they lose on their $ denominated debt. In
contrast to Asia, Latin America governments which detain huge foreign
liabilities would suffer from an undervalued domestic currency that would
raise the government cost of borrowing and the debt service.
III 4) Capital market liberalization

34

If a developing country is capital starved and if the rate of return is higher in

this country than in the rest of the world, capital market liberalization should
enhance growth as foreign capital investment would flow in, generating
jobs and real growth.
However it is not always the case for two reasons :
-

because of the risk and because of market failures capital could

flow uphill, from less developed countries to developed countries . This

was the case in Russia in the 90s and in Africa today.
-

Short term capital inflows are very unstable as they depend on the

international differentials of the real rate of capital return. This could be

very destabilizing as it was the case in the 97 East Asian crises.
What are the consequences of short term capital inflows ?
-

the domestic money appreciates

there is a surplus in the current account which allows increased

consumption of imported goods and may trigger an inflationary spiral

-

there is a spur in the real estate and equity markets

the export sector is weakened as it is loosing its competitive edge

What are the consequences of capital outflows ?

Capital outflows :
-

force a credit contraction which hurts domestic investment. As the

central bank has to increase the domestic rate of interest it will further
depress investment
-

depress the rate of exchange and increase the value of the $

denominated debt . This will lead to an increase in the public budget deficit
and in turn may force a squeeze of government spending.

35
-

Central banks are often forced to raise interest rates in order to

stop capital outflows . This will have adverse effects on fiscal policy,
particularly in countries which have a large public debt. The increase in the
debt service has to be offset by cutting back other forms of public
expenditure to avoid a public finance deficit. Sometimes governments are
forced to reduce the level of deficit and maintain a primary surplus to repay
debt. As the actual level of public spending contracts the economic
downturn worsens.
In short the problem is that speculative capital inflows do not increase
productive investment ( or increase it only marginally ) but capital outflows
depress productive investment.
Some countries like Chile have been encouraging foreign direct investment
with fiscal incentives while restricting short term capital flows. Long term
direct investment needs in fact to be encouraged as it is usually
accompanied by new technology, new know-how and training for the
domestic work force. The problem is that it is easier and cheaper to borrow
short term on world capital markets and redirect these flows to domestic
investment banks than finding long term locked capital.

36

C H APT E R

DEBT

IV

POLI CY

37

A country external debt includes the stock of debt owned by non residents,
governments , businesses and institutions repayable in foreign currency.
External debt includes :
- short term debt with a maturity of less than one year
- long term debt
- use of IMF credit and facilities offered by foreign central bank

From the early 70s onwards nominal LSD countries external debt increased
regularly :

38
Billions $
70

49

76

157

82

816

92

1662

01

2322

Until the end of the 60s the external debt of developing countries was
reatively small and primarily a sovereign debt towards international
financial institutions such as the IMF and the World Bank or foreign
governments. In fact there was no international capital market in which
LDC could tap, since, due to the US balance of payments surplus there was
only a small amount of dollars circulating outside the US. An international
market for capital appeared at the end of the 60s with the deficit of the US
balance of trade, itself due to the Vietnam war. This deficit created a stock
of loanable funds outside the United States on which the LDC could draw
upon.
The quadrupling of world oil prices in the 70s poured tens of billions of
petro $ into the global banking system which were partly recycled as loans
to LDC at low interest rates - at the end of the 70s the world real rates of
interest were negative.
The LDC had to sustain external shocks including oil price rises (73 -74 ,
79-80) and falling commodity prices . As a consequence LDC accumulated
huge trade deficits that they tried to fund through external borrowing. It
should be noted that a large part of the debt accumulated during the 70s was
used as a means to finance macroeconomic imbalances ( budget or balance

39
of payments deficits) not as a means to finance productive investment.The
total external debt of developing countries reached $ 406 billion in 1979.
At the beginning of the 80s the real rate of interest jumped due to the
restrictive monetary policy of the US.At the same time export earnings of
LDC began to fall due to the fall of export commodities ( coffee, cocoa,
iron, copper, oil...) This led to a considerable increase in the debt service
payments and negative transfers ( see box)

Basic transfer
Basic transfer BT is defined as :
BT = d D r D RP
In which d is the rate of increase of total external debt
r is the rate of interest on external debt
RP is repayment of principal

Countries like Nigeria, Argentina, Ecuador and Peru experienced

negative growth rates and faced severe difficulties to pay the debt

40
service out of their export earnings. In 1982 Mexico declared a
moratorium on debt payments. By 1984 the developing countries
were paying $ 10.2 billion more to the commercial banks than they
were receiving from themin new loans.
The debt crises ( Mexico, Peru, Brazil , Argentine , Chile...) of the
80s explain the change of policy of these countries which had to
readjust their budget and spur their exports.
In the 80s numerous plans to relieve or restructure the debt burden
were put forward.

Defaulting

Nobody gains from defaulting.

Creditors loose . How bad a debt is, it appears as a liability in the
creditors balance sheet.
As for the debtor , defaulting means that that he will be barred from
world financial markets.
This explains why debtors and creditors generally agree to roll over
the debt or reschedule it ( to accept to change the dates of payment ,
principal and interest).
The writing down of the sovereign debt of highly indebted poor
countries (HIPC) .There have been several initiatives to conceal this
debt :

41
-

by F.Mitterand at the La Baule meeting

by the British government in 90

by the World Bank in 97, 99, 2000

etc

For commercial debt, debt relief could be negociated through

consortiums ( under the aegis of the World Bank , the Paris club, the
London club).
In 1989 the Brady plan linked partial debt forgiveness and IMF
financial support to LDC commitment to adopt stringent adjustment
programs and a free market policy. It asked commercial banks to
reduce their LDC exposure through voluntary debt write off in
exchange for newly created bonds partly backed by IMF or the world
bank. One third of the outstanding debt was sold with a huge
discount or exchanged for state owned assets such as public
companies or even national parks. The Brady bonds became in the
90s the dominant market instrument in emerging markets, reaching a
peak of 156 $ billion in March 1997. However after the debt
reduction of the last years it has virtually disappeared today.
In the 90s, 80 % of the outstanding debt had been restructured. In
1992 Brady-type restructuring accords were signed with Brazil and
Argentina. However the situation was still worrying in sub-saharan
Africa in which there had been little debt relief. Debt service
payments were four times as much as public expenditure on health
and education. In 1996 an initiative to address the debt problems of
highly indebted poor countries was launched by the G7.
The financial liberalization oif the 90s permitted huge inflows of
short- term loans. This hot money was borrowed short on
international financial markets but was lent long to domestic

42
investors too often for speculative motives as in the case of Thailand.
This created sheet imbalances for domestic and financial
intermediaries which triggered Mexicos 1992 crisis and the
subsequent 1997 East Asian crisis.

How debt buy backs could benefit creditors not debtors

In 1988 Bolivia received $ 34 million from donors to buy back a portion of its
commercial debt . Before the buyback was planned the market valued Bolivia debt at 7
cents to the $.As the debt was 757 millions its market value was 53 million.
After the buyback was announced the debt was sold at 12 cents to the $, so the market
value of the debt jumped to 90.84 million. Bolivia lost 90 53 = 37 million less 34
million given by the donors = 3 million.
Creditors gained 5 cents to the dollar .

Since 2000 thanks to high commodity prices and debt forgiveness

programs many countries are digging themselves out, paying old debts
and avoiding new ones. Argentina , historically a serial defaulter,
which had $ 100 billion worth of debt only in 2001, ended its
relationship with the IMF in 2006 and is paying more money back to

43
its creditors than it is borrowing in fresh loans or bonds. Mexico,
Brazil, Indonesia, the Philippines, South Korea have taken steps since
2000 to insulate themselves from a future financial crisis and are
husbanding resources rather than spending them by running surplus
accounts and by building foreign exchange reserves. Commodity
exporters including Chile and Algeria have used stabilisation funds to
save substantial parts of their surplus.
As for governments who do issue bonds, they generally prefer to do so
locally rather than in international markets which is somehow
surprising. In fact it has never been more attractive for emerging
countries to borrow internationally as a glut of world savings has
driven interest rates and risk premium on historic lows. Some countries
take advantage of the new appetite of investors for emerging market
bonds by issuing bonds of longer maturities thereby reducing the ratio
of short term debt. In short emerging economics are now on more solid
ground than ten years ago and , as the countries that used to be
epicentres of crisis as Argentina, Brazil or Mexico , do not look
particularly vulnerable , a systemic financial full- blown crisis looks
highly improbable. The next crisis will come from something different
and of course unexpected.

Summary of External Debt and Debt Service

Emerging and developing countries
External debt
Billions of U.S. dollars

1999 2000
2008

2001

2002 2003 2004 2005 2006 2007

44

Total LDC
4,118

2,454

2,372

2,388

2,460

2,687

2,931

3,013

3,342

3,762

Africa
255

291

283

275

288

312

328

295

245

243

Developing Asia
1,070

692

658

674

678

711

767

805

882

952

Middle East
387

182

177

173

178

192

217

237

299

354

Latin America
86

792

759

771

762

790

797

751

748

834

Debt-service payments
Billions of US dollars
Total LDC
672.4

397.9

446.9 424.4 416.9 466.2 478.9 597.4 700.5 644

Africa
28.7

26.6

27.6

Developing Asia
139.4

92.6

93.8

Middle East
34.6

19.1

19.4

Western Hemisphere
171.9

26.8
100
22.4

22.5

27.3

109.6

109.2

15.4

19.6

179.1 187 169.4 154.7

161.8

30.3

36.2

54.1 36.6

99.3 112.8

122.3 128.6

22.2 29
154.3 202.2

36.9

34.6

209.7 174

45

External debt as a percentage of exports of goods and services

Developing countries
1999 2000

2001 2002 2003 2004 2005 2006 2007 2008

155.4 122.4 125.5 119.3 107.8

Africa

227.5 179.9

Dev. Asia

91.4 75.4

69.2

66.8

65.2

183.6 186.2 160.5 131.8 93.0 65.7

58.4

53.7

119.9

93.9 97.8

86.4 74.7 62.4

53

47.2

42.2

41.7

Middle East

93.9

65.7 70.1

67.5 58.6 50.7

40.3

42.8

46.1

45.4

Latin America

224.6 180.8 191.5 188.3 178.9 148.0

116

97.7

97.7

94.2

Debt-service payments as a percentage of export of goods and services

Developing countries
25.2 23

22.3

20.2

18.7

14.9

15.0

14.5

11.4

10.6

Africa

20.8 17.5 17.9

14.5

14

12.2

11.4

14.5

8.8

6.0

Dev. Asia

16

14

11.5

8.1

7.4

6.5

5.7

5.4
4.1

Middle East
Latin America

13.5 14.5

9.8 7.2

9.1

5.8

6.0

5.2

4.9

5.3

4.5

50.7 44.5 42.1

38.2

36.6

28.6

31.2

27.4

20.4

18.7

46

Source : IMF

47

C H API T R E V

F I N AN C I AL C R I S I S

V 1) Why Financial Crises Occur

48
The financial system enables funds to move from economic agents ( or
countries), who save but lack investment opportunities, to agents (countries)
who lack savings but have such opportunities. Financial intermediation
activity increases the efficiency with which capital is allocated. Even small
increases in this efficiency have huge social benefit. International financial
intermediation redistributes capital from excess savings countries ( like oil
exporters) with low capital absorption capacity to capital starving countries.
However financial markets do not perform perfectly. Economic theory has
identified several reasons why financial markets may be inefficient , reasons
based on adverse selection, moral hazard or herding. In fact financial
markets cannot be ruled by an invisible hand but should be monitored by
strong institutions. Understanding the causes of financial crises will help to
define the right policies and institutions to assure a safe framework so that
benefits from the international financial intermediation could be realized.
A financial crisis could be defined as a disruption of financial markets so
that they are unable to channel loanable funds efficiently to economic
agents who have the most productive investment opportunities. This may
lead to sharp contractions in economic activities : if the capital output ratio
is 3:1 an increase of 2% of the efficiency with which the capital is allocated
will be equivalent of 6% of GDP in savings.
Fundamentally a financial crisis may come from seven causes: a
inappropriate macroeconomic policies, a financial panics, a bubble
collapses, a moral hazard, deterioration of the financial sector balance
sheets, deterioration of the non financial sector balance sheets or unhedged
increases of the interest rates.
A macroeconomic policy induced crisis
In the late 1980s and in the first years of 1990s , Mexico and the East Asian
countries carried out financial liberalization. International borrowing
increased dramatically which allowed large current account deficit which

49
were compensated by large amount of short term capital inflows, between 5
and 14 percent of GDP. These countries attracted half of total capital inflows
to developing countries with a narrow interest spread.
This foreign debt, mainly private and short term, was largely unhedged.
Since the exchange rates were considered stable, lenders and borrowers did
not bother to consider hedging. In fact financial intermediaries lacked the
expertise to evaluate and respond to the risk incurred. At an upper level
these countries lacked appropriate financial supervision. Financial
intermediaries considered that th
ey could rely on an implicit central bank safety net. This assumption proved
to be sufficient to reassure foreign lenders and lured them into the mistaken
belief that they did not need to monitor these domestic financial
intermediaries.
These capital inflows were further stimulated by government policies to
keep exchange rates pegged to the dollar, which reduced the immediate cost
of borrowing but proved to have a hidden cost because it encouraged
excessive risk taking which led to huge loan losses. Moreover as the US
economy recovered from the early 90s economic recession, the U.S.
Federal Reserve Bank began to raise U.S. interest rates which in turn raised
the value of the dollar. This meant that the exports of countries with dollar
pegged currency countries began to be less competitive and Southeast Asias
growth slowed dramatically in the spring of 1996.
Short term foreign borrowing was lent long term to finance risky and
speculative investments.For example for the three-year period 1991 1994
credit growth in the Mexican banking sector averaged 20 percent per year.
In Thailand speculative operations in real domestic assets were in fact
financed by short term bank loans.
Public indebtness was used to finance public deficit or the deficit of the
balance of payments in order to maintain overvalued currencies particularly

50
in Thailand, the Philippines and Mexico which experienced real
appreciations between 5 and 10 percent.
There was a lack of prudential and regulatory environment. In some
countries like Thaland, domestic banks were allowed to borrow directly in
dollars. Moreover it was considered that the domestic financial institutions
were backed by their central banks. Links between banks and private
borrowers were sometimes based on corruption. As a consequence non
performing loans increased as a percentage of total bank loans ( as much as
16 percent according to Miskin 1999 table 2).
The ratio of short term denominated in foreign currencies to central bank
reserves in foreign currencies was high more than 1.5 in Thailand ,
Indonesia and South Korea in June 1997 -in all the crisis countries which
made it difficult for some countries to meet their short term obligations
when confronted with a massive reversal of short term financial flows. In
fact such high ratios of foreign currencies illiquidity indicate a high
probability of a depreciation of the domestic currency.
Fundamentally a depreciation of the debtors currencies was unavoidable.
To pay the interest on its debt Mexico had to realize a trade surplus which
depends on a depreciation of the peso.
Macroeconomic policy mistakes played some role in East Asian and
Mexican crises. However large scale borrowing by itself does not
necessarily leads to a crisis. More important is how the current account is
financed ( by short or long term capital inflows) and how the capital is used
( in productive or in speculative investments)

A financial panic
A financial panic could be defined as a situation in which creditors suddenly
withdraw their loans from a solvent borrower. This is particularly the case if

51
short term debts exceed short term assets, if no financial creditor is large
enough to pay off existing debts and if there is no lender of last resort. In
this case it is rational for each lender to withdraw its funds if the other
lenders are fleeing from the borrower.

Bubble collapse
Speculators may buy an asset above its fundamental value in the expectation
of a capital gain. Prices never go to the sky so one day asset prices collapse.

Moral Hazard crisis

Banks are able to borrow funds on the basis of implicit or explicit public
guarantee to bank liabilities. Without appropriate supervision these banks
can use these borrowed funds in risky ventures.

Adverse selection and moral hazard

The core of a financial intermediary job is to make judgements about which
investment opportunities are more or less creditworthy. Thus a financial system
must struggle with problems of asymmetric information, in which one party to a

52
financial contract has much less accurate information than the other party. For
example, borrowers who take out loans usually have better information about the
potential returns and risk associated with the investment projects they plan to
undertake than lenders do. Asymmetric information leads to two basic problems in
the financial system (and elsewhere): adverse selection and moral hazard.
Adverse selection occurs before the financial transaction takes place, when
potential bad credit risks are the ones who most actively seek out a loan. For
example, those who want to take on big risks are likely to be the most eager to take
out a loan, even at a high rate of interest, because they are less concerned with
paying the loan back. Thus, the lender must be concerned that the parties who are
the most likely to produce an undesirable or adverse outcome are most likely to be
selected as borrowers. This outcome is a feature of the classic lemons problem
analysis first described by Akerlof. In that example, partially informed
buyers of used cars may refrain from purchasing a car at the lowest price,
because they know that they are not fully informed about quality, and they fear that
a low-price car may also be a low-quality car. In the case of capital markets,
partiallyinformed lenders may refrain from making loans at high interest rates,
becausethey know that they are not fully informed about the quality of borrowers,
and they fear that someone willing to borrow at a high interest rate is more likely to
be a low-quality borrower who is less likely to repay the loan. Lenders will try to
tackle the problem of asymmetric information by screening out good from bad
credit risks. But this process is inevitably imperfect, and fear of adverse selection
will lead lenders to reduce the quantity of loans they might otherwise make.
Moral hazard occurs after the transaction takes place. It occurs because a
borrower has incentives to invest in projects with high risk in which the borrower
does well if the project succeeds, but the lender bears most of the loss if the project
fails. A borrower also has incentives to misallocate funds for personal use, to shirk
and not work very hard, and to undertake investment in unprofitable projects that
serve only to increase personal power or stature. Thus, a lender is subject to the
hazard that the borrower has incentives to engage in activities that are undesirable
from the lenders point of view, that is, activities that make it less likely that the
loan will be paid back. Lenders often impose restrictions (restrictive covenants)
on borrowers so that borrowers are less likely to engage in behavior that makes it
less likely that they can pay back the loan. However, such restrictions are costly to

53
enforce and monitor. The potential conflict of interest between the borrower and
lender stemming from moral hazard again implies that many lenders will lend less
than they otherwise would, so that lending and investment will be at suboptimal
levels.

Mismatch in Financial Sector Balance Sheets

Weakened financial intermediaries balance sheets lead to a contraction in
lending, which slows economic activity. Weakended balance sheets may come

from a rise in interest rates or from a problem of asymetric information (see

box). It could lead to bank panics if there are simultanous failures of
financial institutions and multiple contractions in deposits which in turn will
lead to further deterioration of bank balance sheets.
However these bank panics may be avoided if the monetary authorities take
the necessary steps, providing enough credit to the financial intermediaries
to restore confidence, steps that they usually take. The problem is then a
problem of moral hazard since financial intermediaries are prone to take
more risks if they can rely on a Central Bank safety net.
Increases in Interest Rates

Increases in interest rates have a direct negative effect on bank balance sheets

as the assets of a bank have longer duration than its liabilities, a bank
borrowing short and lending long. Thus, a rise in interest rates directly causes a
decline in their net worth, since, in present value terms, the interest rate ( or the

discount rate ) rise lowers the value of assets with the longer duration more than
it lowers the value of liabilities which have shorter duration.

As interest rates rise the most prudent borrowers - or those whose the less
expected rates of return on borrowing capital - are more likely to decide that it
would be unwise to borrow. The financial intermediaries will be left with
borrowers with the riskiest investment projects since they are those who are

54
willing to pay the highest interest. Thus higher interest rate lead to an adverse
selection : the higher interest rates are, the higher the likelihood that the

lender is lending to a borrower with a high credit risk. In other terms higher
interest rates will dilute the quality of potential borrowers. Financial

intermediaries will then react by limiting the number of loans they make.
Deterioration of Nonfinancial Balance Sheets

Deterioration of the balance sheet of non financial firms is the most critical
factor in explaining financial crises. This deterioration may come from a
decline of the value of collaterals, a decline of the net value of borrowing
firms or from an unexpected non hedged change of the exchange rate.
Change in the value of collaterals
Lenders use collateral in order address asymmetric information problems since
collateral reduces the consequences of adverse selection. If a borrower defaults on
a loan, the lender can sell the collateral to make up for some of the losses on the
loan. But if asset prices in an economy fall, and the value of collateral falls as well,
the lender will not recoup the losses from the loan.
Net value of firms and moral hazard
If a firm defaults on its debt payments, the lender can take title to the firms net
worth, sell it off, and use the proceeds to recoup some of the losses from the loan.
Thus the possibility to take title by the lender reduces moral hazard. The higher the
net worth of a firm the higher the stakes in case of default since borrowers now
have more at stake, and thus more to lose, if they default on their loans. In other
words the high net asset worth of the borrower reduces moral hazard. But if the
firm net worth decreases as in case of stock market crash not only will the financial
intermediaries have more difficulties in recouping their loss but borrowers will
have more incentives to engage in moral hazard .

Changes in the exchange rate

55
Most of the foreign debt of emerging countries is denominated in foreign
currencies. An unanticipated depreciation of the domestic currency will increase
the debt burden of domestic firms ( as well as domestic financial

intermediaries). Since assets are denominated in domestic currency and do

not increase in value, their net worth declines relatively to the firms foreign
liabilities creating a deterioration of the balance sheets. This was a major
cause of East Asian economic crisis in 1997 following the devaluations of
the won and of the baht .
The underlying differences between these seven types of crises lead to
different types of prevention and appropriate policies. The remedy in case of
a financial panic would be a lender of last resort but this would make things
worse in case of moral hazard induced crisis. Unfortunately the distinction
between the above cases are somehow too theoretical and in reality they are
intertwined.

V 2 ) Contagion
International financial contagion has been at work in recent financial crises.
This could be explained by :
-

common shocks ( rate of interest increase on world financial

markets, fall of commodities prices) ;

trade linkages which lead to a decline of the demand for imports of

a commercial partner ;

competitive devaluation ( beggar my neighbour policy )

between countries competitive among themselves or in third
markets ;

market illiquidity which leads highly leveraged financial

institutions to withdraw from healthy places ;

investorsirrational behaviour ;

56
-

unattainable Nash equilibrium : suppose that every investor in a

country bonds may expect to earn 10% if the country stays solvent
lose its capital if the country goes bankrupt but neither gains or
loses if he withdraw its capital before the other investors. If
nobody withdraws the country will be able to give a 10% rate of
return of each investors capital. It would be a Nash equiibrium
not to withdraw but certainly not an attainable one.

V-3 ) Policy implications of the crises

In order to avoid financial crisis the following measures should be
considered:
1)

The central bank should provide a safety net and refinance the

troubled financial institutions in order to avoid bankruptcies. However this

safety net has two negatives:
-

it increases the incentives for excessive risk taking by banks

it increases the supply of money and credit and therefore the rate of

inflation.
The risk is thus that, in making credit more available in order to rescue the
financial sector and in playing the role of lender of last resort, central banks
will loose credibility to fight inflation and set off currency depreciation and
higher interest rates in expectation of future inflation. This is why an
international lender of last resort is to be preferred. This international lender
of last resort should be funded with enough mobilizable capital which can
be only be obtained with the approval of the US authorities ( since the
bailouts will be denominated in US $) .
An international lender of last resort could be perceived to be ready to bail
out irresponsible financial institutions and this may lead to excessive risk
taking in other terms lead to a moral hazard problem. However, even if

57
drivers react to seabelts and airbags by driving faster this is not a reason to
dispense with airbags.

2)

The government should forge a strong bank supervisory board which

should have 4 characteristics :

-

it should be staffed with experts and provided with adequate

resources. Experts should be trained as many developing countries lack

experts;
-

it should promote proper accounting standards and disclosure

requirements which are crucial for an healthy banking system. Without

appropriate information both markets and bank supervisors will be unable to
montor banks to deter excessive risk taking;
-

it should promote a carrot and stick policy making sure that managers

and stockholders of insolvent institutions are punished;

-

the central bank should have sufficient independence by engaging in

regulatory action;
3)

Financial liberalization is critical to the efficient functioning of

financial markets provided that regulatory and supervisory structures are in

place.
A legal framework should be put in place as the inadequacies of legal
systems in developing countries are a serious impediment to the
development of financial markets. In particular :
-

if property rights are not clearly defined or hard to enforce , collateral

cannot be effective;
-

cumbersome bankruptcy procedures may cause long delays in

resolving conflicting claims and so delay recovery from a financial crisis.

58

59

C H API T R E VI

LAT I N

AM E R I CA S

V 1 ) The Mexico crisis

The Debt Crisis of the 1980s

FI N AN C IAL

CRISES

60
In mid-1982, Mexico was deep in an economic crisis which was due to
macroeconomic mismanagement and to an adverse external environment. In the
late 1970s, the Mexican government engaged in a spending spree, based on the
mistaken assumption that the rise in world oil prices and the availability of cheap
external credit would continue. (At that time, oil represented over 70 percent of
Mexicos exports.) The fiscal deficit increased inflation rates and the trade deficit,
but the fiscal and external gaps were filled with external borrowing. Total public
debt rose from $23 billion in U.S. dollars in 1977 to $53 billion in 1981. But in
1981,the price of oil began to fall. External credit became more expensive as a
consequence of the tight US budgetary policy and some foreign banks stopped
lending. This unfavorable international environment exacerbated the consequences
of domestic imbalances and contributed to rampant inflation, capital flight, and
chaos in the financial and foreign exchange markets in 1982.

Macro economic indicators

1978 1983
1978

1979

1980

1981

1982

1983

61

Peso per $ end of period

0.02

0.02

0.02

0.02

0.01

0.14

-2783

-3953

Net foreign assets owned by

banks (million pesos)

-259

-294

-359

-661

331

433

574

850

2496

3192

2277

3942
56.6

Claims on central government

by monetary authorities (M.P)
Quasi Money (M.P.)

485

662

941

1496

Average cost of funds (%)

15.1

16.3

20.7

28.6

40.4

Rate of inflation (%)

Real average cost of funds
Current account M $

n.a.

-5409

-10422

-16240

-5889

5866

Financial account M $

n.a.

5120

11508

26601

2923

-3275

GDP vol. 2000=100

49.9

54.5

64

63

59

61

Source : IMF

From Stabilization to Recovery

Throughout the 1980s, the Mexican government focused economic policy on
restoring stability. In particular, it focused on lowering the rate of inflation and
keeping the loss of international reserves in check. Initially, the policy response
followed the traditional International Monetary Fund (IMF) recommendations of

62
a drastic reduction of the fiscal deficit and a large devaluation of the peso. The
Mexican government rescheduled its foreign debt .
However this attempt at stabilization failed. It failed partly because Mexico was
subject to additional external shocks such as a fall in oil prices in 1986. But it also
failed because the corrective measures fueled inflation. The devaluation and higher
public prices (to cut the fiscal deficit) caused prices in the economy to rise.
Inflation tends to increase the fiscal deficit ( the so called Tanzi effect). The
Mexican authorities opted for combining fiscal discipline, incomes policy and the
pegging of the peso to the dollar to bring down inflation . This policy combination
successfully reduced inflation from monthly averages close to 10 percent at the
beginning of 1988 to about 1 percent by years end. However, growth had not been
resumed, as shown in Figure 1. For the period 198388, average GDP growth was
equal to 0.2 percent (and negative in per capita terms).
Economic difficulties, not political ones, were at the heart of Mexicos slow growth
recovery. The adverse economic conditions continued through the 1980s: in
particular, high real world interest rates,low availability of credit and low oil prices.
By 1986, the price of oil had declined more than 60 percent below its 1981 level.
These adverse external conditions resulted in large net resource transfers to the rest
of the world. The high interest rates kept Mexicos debt payments high, while the
lack of external credit meant that l ittle foreign capital was coming in. Moreover,
these effects were compounded by capital flight, which after 1983 was itself a
result of the difference between the rate of capital return ( real or anticipated)
between Mexico and the rest of the world , and particularly the United States .
Between 1983 and1988, net resource transfers from Mexico to the rest of the world
averaged 5.9 percent of GDP.
Large resource transfers to the rest of the world present severe economic
problems. Real domestic interest rates have to be high to attract capital inflows and
deter capital flight, but high interest rates negatively affect domestic investment. In
addition, high domestic interest rates make budgetary discipline difficult as it
increases the domestic debt service.
However at the end of 1988, Mexico had reestablished the preconditions
for growth. Mexico had embarked on an ambitious market oriented program
which had four basic components :

63

-the opening of the economy to international competition which led to the North
American Free Trade Agreement in 1994
- a process of privatization or reprivatization of the banks and selling of several
public enterprises (including the privatization of Telmex, the telephone company,
in 1990).
- restrictive monetary and fiscal policies in order to attain exchange rate
stabilization
- a social agreement ( the Pacto ) between the government, the private sector
and the trade unions on wage increases.
This plan was supported by an agreement with the foreign commercial banks to
reduce Mexicos medium- and long-term debt under the so-called Brady Plan.
In1989, the IMF signed an extended fund facility, and the World Bank and the
Inter-American Development Bank (IDB) increased their lending substantially
In late 1987 the rate of inflation had reached a historical high (140%) and the
authorities designed an ambitious stabilization program centered on :
-

a temporary freeze of nominal wages

a fixed exchange rate ( february 1988) moving to a regime based on a

preannounced exchange rate (1989) and in november 1991 to a narrow exchange

band with a sliding ceiling.

From Slow Growth to the Peso Crisis : the road to collapse 1991-1994

Starting in 1991, the growth rate of per capita gross domestic product rates turned
positive for four consecutive years, the first time that per capita GDP had grown for
four consecutive years since 198l. When NAFTA was finally approved in 1993,
Mexico appeared to be on a firm path to economic prosperity.
However this recovery Mexico became unsustainable. The current account of the
balance of payments deteriorated sharply. Mexicos exports grew at a slower pace
and imports surged as a result of the appreciation of the peso. Mexicos output
growth slowed down in 1992 and 1993, which was especially disappointing given

64
the important economic reforms (trade liberalization, privatization of state-owned
enterprises, and deregulation of markets) that had been introduced.
Supported by prudent monetary and fiscal policies the nominal peso dollar rate was
remarkably stable until 1993, a precondition of the NAFTA agreement.This the
attempt to reduce inflation using the exchange rate as the nominal anchor led to a
real appreciation of the peso since the Mexican rate of inflation was higher than the
US one. However the NAFTA agreement allowed a surge in private capital inflows
which allowed Mexico to finance its current account deficit on the order of 6-7 %
of GDP in 1992-1994. In the long term this trend was unsustainable because the
country lacked sufficient foreign exchange to finance the rapidly growing current
account deficit. At some point to pay for the debt service the current account had to
become positive ( this point was made by Keynes on the German debt in the early
20s).

During 1994 Mexico confronted a number of political shocks such as the peasant
uprising in the state of Chiapas in January, the assassination of Luis Donaldo
Colosiothe PRIs presidential candidatein March, and the assassination of the
partys Secretary General in September. It also faced a rise of interest rates in the
United States. When returns were higher in the United States and Mexicos
political future became uncertain following the Colosio assassination, capital
simply left.
But the Mexican authorities also made some policy judgements that turned out
badly. In 1994, Mexicos strategy was based on the presumption that bad news
(political shocks) was temporary and that good news (NAFTA, fiscal prudence,
market-oriented reforms) was permanent and that capital flows would resume.
A fixed exchange rate
In order to sign up the Nafta agreement a decision was made to maintain a fixed
exchange rate with the dollar .The (quasi-)fixed exchange rate meant that Mexicos
peso appreciated in real terms in the early 1990s. Foreign goods became relatively
cheap which hurt domestic output.
Sterilizing short term capital outflows

65

After the international capital flows reversal in 1994 the Mexican authorities
decided to sterilize the short-term capital outflows by increasing domestic credit.
(Sterilizingcapital outflows meant that when international reserves fell because
people demanded dollars in exchange for pesos, the Mexican central bank
compensated for the fall in pesos circulating by buying bonds in the open
market).By sterilizing outflows, the hope was to keep interest rates from rising and
avoid a crisis of the banking sector which already had a good share of
nonperforming loans.
Tesobonos
Also, to deter capital outflows, the government encouraged investors who feared a
devaluation to switch from peso denominated short-term government debt to debt
indexed to the dollar, called tesobonos. As a result, the composition of foreign
investment in Mexican government securities shifted dramatically. In January
1994, only 6.4 percent was in tesobonos; by August the share was equal to 63
percent. This meant that the (short-term) dollar liabilities held by the government
rose sharply.

The beliefs that good economic news would soon outweigh the bad, and that
sterilizing capital outflows and keeping the peso-dollar rate unchanged were the
appropriate response were, at least in retrospect, clearly wrong.
Confidence in Mexicos prospects was shattered when, at the end of 1994, Mexico
ran out of international reserves and faced a serious foreign exchange crisis, which
became popularly known as the tequila crisis. By the end of november the Bank
of Mexicos international reserves at $US 12.9 billion were covering only 40% of
the short term public debt or 10% of total short term liabilities of the banking
system.
Devaluation
After President Zedilo was sworn into office the authorities did not maintain the
fixed exchange rate without a tightening of the monetary and fiscal policies. As a
result to cover the peso lost half of its value in three months. Following the

66
devaluation the Mexican government was unable to roll over its $ 28 billion short
term $ denominated debt ( tesobonos) .
Financial rescue
A financial rescue package was needed. $25 billion assembled by the IMF and
the United States in early 1995 stopped the peso from collapsing and prevented the
crisis from spreading to other countries. Its success can also be seen in how rapidly
Mexico recovered its access to international capital markets and in the fact that the
Mexican government fully repaid its loans to the United States several years ahead
of schedule. Had it not been for the rescue package, Mexicos output would almost
certainly have contracted much more drastically and recovered much more slowly.
Precious time lost
However, it should be noted that precious time was lost by both the Mexican
government and the international community before putting together an adequate
response. It was only well after two months into the crisis that Mexico put together
a credible macroeconomic program and that the financial rescue was ensured. This
delay meant a larger contraction in output that would have been the case otherwise.
In particular, if an adequate response had been in place more quickly, the peso
might have devalued less and domestic interest rates could have been lowered. This
would have meant fewer bankruptcies and a less severe banking crisis.

Mexico
Financial flows 1993 1995
1993
Current account balance (B.US$)
Gross national product (B.US$)
International reserves (B.US$)
Net flows on debt, total (B. US$)
Net transfers on debt, total (B. US$)
Short-term debt net flows (B. US$)
Short-term debt outstanding (US$)

-2.34
392
25
13
5
12
36

1994
-2.96
408
6
7
-2
3
39

1995
-1.57
273
17
26
15
-2
37

67
Short-term debt/Total debt (%)
Short-term interest payments ( US$)

28
1.8

28
2

23
3

Source : World Bank Global Development Finance

Table
Macroeconomic Indicators: 19911998
1991 1992 1993 1994 1995 1996 1997 1998 1999
GDP growth rate

4.2

3.6

2.0

GDP per capita

2.3

1.7

0.1 2.6

Inflation

22.7 15.5 9.8 7.0

Fiscal Deficit

20.5

Real Exchange Rate

Real Wage
Cur. Ac.Bal. (Bil.$)

1.5

4.4

0.7 20.1

91.1 78.5 72.9 75.2

6.6

8.9

7.2 3.7

26.2 5.2

6.8

4.8

3.7

27.8 3.4 5.0

3.1

1.7

35.0 34.4 20.6 15.9 16.6

0.0 0.0 20.7 21.2 21.1
125.6 129.0 115.2 115.8 105.0
213.5 211.1 20.6 2.2

1.4

214.6 224.4 223.4 229.7 21.6 22.3 27.4 215.7 214.0

68

Note: Annual percentage change except when noted otherwise.

.
Source: IMF

Peso/$ end of period

1991

1992

1993

1994

1995

1996

1997

1998

1999

3.07

3.12

3.11

5.33

7.64

7.85

9.8

9.5

Source : IMF IFS

Balance of Payments
Million of dollars

1991 1992 1993

Current account

1994

1995 1996 1997 1998

-14888 -24442 -23400 -29662 -1576 -2536 -7694 -16017

Source : IMF

Balance of payments
Financial account
Million of dollars

69

1991
Direct investment

4742

1992
4392

1993
4389

1994
10972

1995
9526

1996

1997

9185

12829

1998
12416

Portofolio Investment
liabilities

12741

18041

28919

8182

-9714

12585

4703

1027

Source I

Total domestic credit :public and private sectors

Billion Peso
1991
Domestic credit

358

1992

1993

1995

1996

454

516

697

911

1997
944

1998
1685

Source : IMF

An important lesson of this experience is that fixed (or quasi- fixed) exchange rate
regimes can help to stabilize prices, but can impose severe costs when they become

70
unsustainable. Learning from the experiences of 1994 exchange rate policy in
Mexico has been flexible since the end of 1994.

The Mexican peso crisis showed that in a global economy of huge capital flows
and derivative financial instruments, major financial crises no longer necessarily
mean that a country is running large fiscal deficits. Instead, they can arise largely
as a result of external shocks and financial volatility.

VI - 2 ) Argentina
Origins and developement

After years of hyperinflation Argentinas monetary authorities tried to

introduce a new currency the Austral in order to restore confidence (see
G.Grellet Les politiques conomiques des pays du sud PUF 1992) . This
new currency had to be backed by foreign reserves for which new loans
were required. The State eventually became unable to pay the interest of its
debt and defaulted. The government tried to delay the crisis by emitting
money. The economy collapsed and inflation backlashed (3000% in 1989).
President Alfonsin resigned six months before the end of his term.
To restore confidence in the currency the new elected president Carlos
Menem fixed by law, on January 1 1992, the value of the Argentine
currency at 10.000 australes ( or a peso) for a dollar with a fre convertibility.

71
As a result confidence returned. Inflation rates and the monetary rate of
interest dropped sharply.
For a fixed exchange parity with the dollar to be sustainable Argentina
should have maintained a positive balance of payments account. This has
not been the case. Argentina had a huge foreign debt service. Government
spending continued to be high. Moreover the domestic inflation rate was
higher than the US rate so imports were cheaper than domestic production.
Exports were harmed by the international reevaluation of the dollar. This
had the effect of reevaluing the peso against the major international
currencies.
To sustain the foreign account deficit Argentina had to increase its foreign
debt. The IMF continued through the 90s to lend to Argentina and
postponed its payment schedule.
In 1999 the undesirable effects of an overvaluated fixed exchange rate
showed forcefully. Brazil, facing its own financial crisis, devalued its
currency, hurting Argentine exports, 30% of which were traded with Brazil.
Argentinas GDP dropped by 4%. As a financial crash seemed unavoidable
people drew large sums of cash and converted them in dollars. This caused
a further deterioration of the balance of payments account.
In 2000 the IMF agreed to a three year 7.2 billion $ stand- by arrangement
conditioned on a strict fiscal adjustment and the assumption of a 3.5% GDP
growth ( which turned out to be 0.5%). The government cut one billion $ in
federal budget. In december IMF organised a US $ 40 billion multilateral
assistance package.
In June 2001 the government announced a 29.5 billion $voluntary debt
restructuring in which short term debt was exchanged for new debt with
lower maturities and higher interest rates. In september, based on
Argentinas commitment to implement a zero deficit law, the IMF increased
its lending commitment by $ billion 7.2. As federal revenues declined

72
provincial bonds were used as a mean to pay public salaries. In november
Argentina had to conduct a second debt swap, exchanging 60 billion $ with
an average interest rate of 11.5% for extended maturity debts carrying only a
7% interest rate.
At the end of november 2002 a run on banks begun. 2 billion $ were
withdrawn in one day. To stop the financial haemorrhage the government
froze all bank accounts for twelve months, allowing only 1000 $ to be
withdrawn monthly.
The interim government faced the impossibility of meeting debt
payments.The government announced on December 7 that it could no
longer guarantee payment on foreign debt. Foreign debt was estimated at 93
billion dollars at the end of 2001.
On January 6 2002 the fixed 1-to-1 parity with the dollar was abandonned
and in February a new exchange rate regime was established, the exchange
rate being henceforth determined by market conditions.The peso suffered
quickly a huge depreciation, falling at 4-to-1with the dollar ( 3.4 -to-one at
the end of the year) which in turn prompted inflation ( 30 % in 2002) since
Argentina depended heavily on imports. The economy collapsed : many
businesses went bankrupt, imported products became inaccessible for the
vast majority of the population and the purchasing power of salaries
dropped heavily as most salaries were not indexed on inflation. The official
rate of unemployment soared at 18% ( 25% non official). Since the quantity
of pesos did not fit with the money demand for current transactions a wide
spectrum of liquid assets circulated ( such as provincial bonds) without any
guarantee that the provinces which had issued them will take them back.
The recovery
Two economic forces have been at work to explain the recovery.

73
Firstly the devaluation of 2002 made exports cheap and competitive while
discouraging imports. However exports did not respond well due to the low
short term elasticity of production and the economic crisis. For exemple the
export volume of wheat declined by 15% between the end of 2001 and the
end of 2002 . The current account surplus came mainly from a drop of
imports, from19.1 billion $ in 2001 to 8.4 billion $ in 2002. Capital which
had flight returned to buy devalorised real assets (capital account credit
jumped from 164 million $ to 410 million $) . The central bank could sell
dollars on the market and the peso slowly reevalued reaching 3.3-to-1 to the
dollar at the end of 2002.
To a certain point the inflow of dollars and the reevaluation of the peso
could have discouraged exports and reindustrialisation. The central bank
intervened to sell dollars to prevent a further reevaluation and stocking them
as reserves which climbed from 15.3 million pesos at the end of 2001 to
58.4 million pesos at the end of 2004. The downside of this policy is that
dollars had to be bought with freshly issued pesos which could have
triggered inflation. The monetary authorities had to neutralise a part of this
monetary emission by an open market policy ( selling bonds on the
domestic financial market). Claims on deposit banks increased from 6
billions pesos at the end of 2001 to 24,8 billions pesos at the end of 2004
and claims on central government increased from 7.4 billion $ at the end of
2002 to 65.5 billion $ at the end of 2004.
Secondly the government succeeded in restructuring about three quarters of
the external debt and in keeping short term speculative capital inflows at
bay. As default was declared in 2002 the financial account turned heavily
negative (- 20 billion $ in 2002, - 15 ;8 billion $ in 2003) and the
government could have had difficult times to finance the debt service. It
finally got a deal with creditors by which 76% of the defaulted bonds were
exchanged for others with 25% to 35% of the original values and at longer
terms.

74
As a result GDP jumped to 8.8% in 2003 , 9% in 2004 and9.1% in 2005.
Inflation rate was 12.5% in 2005 but wages have increased 18% in the
same year.

Main Economic Indicators

1997 1998 1999 2000 2001 2002

Exchange rate

Peso / $

Current Account

Billion $

Capital Account

Billion $

0,06

0,07

Financial Account Billion $

17,6
3,3

Overall Balance

Billion $

-12,1 -14,4 -11,9

-8,9

1 3.06

2.9

2.92

-3,7

8,7

3,2

0,14

0,1 0,15

0,4

0,03

0,19

18,9

14,4

7,8 -14,9 -20,6 -15,8 -10,9

-1,1 -21,4 -13,4

BudgetaryBalance Million Pesos

-4357 4148 8125 -6817 8739 3463

M3

Billion Pesos

n.a.

Consumer prices

2000 = 100

101

2003 2004

90

92,5

102 100,9

92,7

73

-9

-6,9

445 9424

83,8 116,8 147,4

100 98,9 124,5 141,2 147,5

75
Lending rate

9,2

10,6

11

12,1

13,4

Unemployment

rate

13,4

GDP volume

2000 = 100

100 104,3 100,8

11 27,7

51,6

19,1

6,7

18

17,5

16,8

13,6

100 95,5

85,1

92,7

101

14,6

Source : IMF

C H API T R E V I I

THE

E AS T

AS I AN

FI NAN C IAL

CRISIS

76

VII 1 ) The 1997 East Asia financial crisis : the sequence of events
Until 1997 the economies of Southeast Asia enjoyed high growth rates ( 8
12 %) and offered high rates of return on capital. Macroeconomic
fundamentals were good ( see below data for Thailand and south Korea).
Inflation was low ( below 10%). Government budget registered regular
surpluses. Sovereign debt remained at prudent levels. That was a time when
economists spoke of an Asian miracle .
At that time the East Asian economies received an increased flow of funds
from Japan and from the US. As a consequence of the appreciation of the
yen the Japanese economy was hollowed out and Japanese exporters
increased their productive capacity in East Asia. This was made easy by
wide ranging financial deregulation in international markets without
appropriate supervision. The supposed peg of the domestic currencies to the
dollar reduced the risk for investors.

77
Capital inflows can be an engine for growth if they are channeled to
productive investment. This was not the case since they were largely used
for speculative investment in real estate development ( Thailand) or even as
a means to fund the financial imbalances of private companies ( South
Korea). One reason is that high rates of capital accumulation (30-40% of
GDP) in the early 90s led to an oversupply in some sectors (such as the
electronic industry in 1996 but also in automobile construction and
household appliance) at a time when China had implemented a number of
export oriented reforms and Western importers found cheaper
manufacturers in China whose currency was depreciated relatively to the
dollar. Overproduction tended to erode the rates of return on capital and
the rate of growth associated with a given investment rate. As a consequence
capital flows headed for speculative investments particularly in real estate
market rather than into increasing productive capacity of the export sector.
These high levels of capital inflows led to a real appreciation of the
exchange rate (which exceeded 25% in the four countries) and thus to a
slowdown of exports which felt sharply in 1995 and 1996.
The financial systems appeared particularly weak as banks diverted part of
their own working capital towards real estate. The expansion of domestic
credit was financed by foreign short term borrowing. There was generally
inadequate banking expertise and supervision. However investors felt
protected by the implicit guarantee that the central banks would provide the
necessary liquidity in case of crisis. However approximatively 60% of
foreign loans were to debtors for which state guarantee were far from
assured.
Economic stagnation led to a collapse of overvalued assets causing
companies to default on debt obligations and large credit withdrawals from
the crisis countries, causing a credit crunch and bankruptcies. As investors
were trying to withdraw their money the exchange markets were put under
pressure. In order to avoid a collapse central banks raised interest rates and
intervened on the exchange markets. Neither of these policies could be

78
sustained for long. High interest rates depressed the rate of investment and
wreaked havoc on fragilised economies. Buying back its own currency
deplete rapidly foreign reserves and put further pressure on the rate of
exchange as speculators knew that these foreign reserves are not infinite
( they can see the bottom of the barrel as Alan Greenspan put it) : in fact
international reserves were less than the short term $ denominated debt.
When it became clear that it was useless to stand against the tide, the
monetary authorities ceased defending the peg and allowed their currency to
float. But the following depreciation meant that foreign denominated
liabilities increased in value in terms of the domestic currency causing more
bankruptcies.

External financing of five Asian Economies

( South Korea, Malaysia, the Philippines, Thailand, Indonesia)

1994

1995

1996

Current account balance

-24.6

-41.3

-54.9

External financing net

47.4

80.9

92.8

1997

1998

-26

17.6

15.2

15.2

79

The decision of the Thai authorities to stop supporting the baht in July 1997
triggered a contagion effect and the flow of funds to East Asia slowed down
or was reversed. However the depreciation of the Asian currencies led to a
remarkable and quick reversal in their trade balances.
As country after country felt into crisis and became unable to pay their
creditors , the IMF offered rescue packages to enable these countries to
avoid default.
The IMF programs were introduced in Indonesia, Thailand and Korea. They
called for six actions:
-

immediate closures of undercapitalized banks in order to limit the

losses being accumulated by these institutions and restore confidence in the

banking system.
-

full payment of foreign debt obligations backed by bail out packages

mobilized by the IMF in order to restore confidence and upgrade credit

rating.
-

tight domestic credit in order to defend the exchange rate

high interest rate on central banks discount facilities

80

fiscal contraction in order to defend the exchange rate

non financial sector structural changes that aimed at reducing tariffs,

opening sectors to foreign investment and reducing monopoly powers.

These structural adjustment packages ( SAP) had mixed results. Currency
depreciation and stock market collapse continued long after their
implementation. Reasons could be attributed to political uncertainty which
stopped full implementation of the reforms. But there were also questions
about the underlying design.
-

bank closures deepened the panic and led to runs on deposits. This

added to the liquidity squeeze making it difficult to restore normal lending

operations and making foreign creditors more reluctant to roll over their
loans. Pushing banks to be recapitalized in a short period of time led to
severe credit crunches increasing distress for private firms.
-

quantitative credit targets interfered with the central bank lender of

last resort function and increased the credit contraction.

-

after the withdrawal of foreign capital domestic interest rates rose

sharply. There is little evidence that this had a positive effect on the rate of
exchange but it added to the economic contraction and to the financial
conditions of the banks. Highly leveraged borrowers like the Korean
chaebols or the domestic banks were pushed to insolvency as a result.

Lessons to be drawn
Asian nations including South Korea , Japan and China as well as Russia
learned from the 97s crisis and began to build up foreign exchange reserves
as an hedge against speculative attacks. This has in turn led to ever
increasing funding for US Treasury bonds allowing low US interest rates
and housing and stock market bubbles.

81

IMF led bail outs led to a moral hazard risk. In fact it could be argued that
the Mexican bail outs made the way to the East Asian crisis because it made
believe that the risk of speculative lending was low.
Another lesson from the crisis is the uselessness of defending a currency
under attack without sufficient foreign reserves. Japan, Brazil, Russia and
India have weakened their currency and restructured their economy in order
to create current account surpluses.
Other underlying questions are :
-

what has been the role of fundamentals and of speculators psychology

in explaining the crisis ? Some economists have pointed out that investors
were often ignorant of the economic fundamentals of the Asian economies
and had a herd mentality ( for an individual investor what is important is
not the fundamentals of the real economy but what the other investors think
what they are as Keynes pointed out in the example of the beauty contest)
-

what was the role of relative rates of returns between productive

investments and speculative investments ?

is it possible to monitor short term flows of capital and if so is it

desirable ?
-

Is there a case for an international lender of last resort ?

82

VII 2 ) Thailand
The situation at the beginning of 1997
At the beginning of 1997 Thaland GDP rate of growth was 5% . Short term
capital differential was 4% above the US , Japan and CEE average. This led
to huge short term capital inflows.
Macro economic fundamentals 1991 1997
1991

1992

1993

1994

1995

1996

1997

25.2

25.2

25.5

25

25.1

25.6

47.2

GDP growth rate

-1

Rate of inflation

5.7

3.3

5.8

5.8

5.6

9.3

7.8

6.1

7.2

7.8

Baht per $
Official rate
End of period

Interest rate spread

(lending rate libor)

9.4

Real interest rate (1)

9.1

7.3

7.5

5.3

7.3

Real US rate of interest (2)

4.6

3.7

3.5

4.9

6.5

4.5

3.6

0.4

(1) (2)

0.8

8.8
6.2
2.6

7.8
9.2
6.3
2.9

83

Capital flows, short term debt , investment

1991

1992

1993

1994

1995

1996

1997

37.7

41.7

52.6

65.5

100

107.7

109.7

12.2

9.3

19.5

21.2

11.3

11.1

15.7

31.7

32.9

29

30.7

39.1

44.7

42.9

33.1

35.2

43

12.6

6.6

9.2

External debt
Billion $

Gross private capital

Flows % GDP

Private non guaranteed

Debt as % of external
Debt

Short term debt as %

Of total external debt

44.5

44

39.5

34.4

10.9

6.7

- 21.1

Rate of growth of
Gross Fixed Capital

11.3

84

Source : IMF and World Bank

At the beginning of 97 local banks were highly leveraged. They borrowed
short term on foreign markets and lent long term at domestic investors to
fund speculation in the real estate and stock exchange markets.The Tha
central bank did not control the secondary banks as it should have.
Policy alternatives
Before studying the resulting financial crisis we can consider what could
have been the alternative policies in 1996.
When the real estate market exploded, borrowers declared bankruptcies and
foreign creditors began to withdraw their funds.
Tha authorities could have :
-

eased monetary policy by buying the baht on the currency market. The

baht would not have appreciated but this would have created domestic
inflation.
-

run a tighter fiscal position . This would have penalised the domestic

economy over what was largely an external problem.

-

controlled and penalised the short term capital inflows . This kind of

measure was taken by Chili where 30 % of capital inflows had to remain in

the country for at least a year at no interest rate. The problem is that the
Stock exchange is penalised as well as the direct capital inflows in the
productive sector as it difficult to distinguish between speculative capital
inflows and investment capital inflows.
-

cut the interest rate : though this could have been done this would not

have been sufficient to stabilize the baht since it would not have stop the
buying of equities.

85

Development
In march 97 the Tha authorities took three measures:
-

they increased sharply the rate of interest;

they limited real estate credits and capped the fraction of the loan

covered with real estate collateral;

they maintained the peg to the $ against the expectations of the market

which led to massive speculative attacks against the Baht . In May June
the Tha central bank had to spend $ 10 billion in defense of the currency
and raise the interest rate.As a result much of Thailands reserves were lost.
Eventually the Bank of Thaland had to float the Baht with a 18%
devaluation . In October 97 the Baht had lost 50% of its value.
The combined sharp increase in interest rates and the depreciation of
domestic currencies led many estate projects into bankruptcy since real
estate developers had borrowed in unhedged dollar denominated loans from
domestic bank to finance their projects. Moreover as to the extend that
domestic banks were net dollar borrowers the exchange rate depreciation led
to a sudden loss of bank capital. Some banks went bankrupt.
The collapse in domestic bank capital and the withdrawal of bank credit led
to a severe contraction of bank lending and a sharp reduction of the GDP.
The fall of the baht set off a panic and attacks by speculators on the
Malaysian, Indonesian and Philippine currencies. However the won and HK

86
$ remained stable since the authorities had enough reserves to counter attack
the speculators.
VII 3 ) Korea
In 1960 Korea was one of the poorest economy in the world but at the
beginning of the the 90s it has emerged as the 12th largest economy.
Macroeconomic fundamentals were seemingly good :between 1995 and
1997 the output was growing at more than 6%, inflation was moderate,
and the current account deficit was less than 2% of the GDP.
Korean macroeconomic main indicators

GDP rate of growth

95

96

97

8.9

6.7

98
-6.6

99
10.8

Current account balance

Billion US $

-8.5

-23

-8.1

40.3

24.4

36.6

36.7

35.1

29.7

27.7

11.8

7.3

-2.2

21.1

3.6

7.1

3.8

3.1

-2

Gross fixed capital

Formation as % of GDP
Gross fixed capital
Formation rate of growth
Rate of inflation

Source : World Bank

87

Korean capital flows and debt

1995

1996

1997

1998

1999

85.8

115.8

136.9

139

130.3

32.6

34

External debt
Billion $
Net external reserves
Billion $

20.3

51.9

73.9

Interest spread
(Lending rate Libor)
Short term debt

2.9

3.3

6.1

9.6

3.9

54.3

57.4

39.2

20.2

26.6

14.2

26.8

16.4

11

16.8

6.1

Gross private capital flows

As % of GDP

12.5

14.2

Use of IMF credit

Billion $

Source : World Bank

00

00

88

Origins of the crisis

The economic structures, built in the 60s proved to be inadequate for an
open economy.
Inadequate financial intermediation
The financial sector structures, while promoting rapid growth, was ill suited
for an open economy facing the international integrated capital markets of
the 90s. The Korean economy lacked an effective corporate governance
system to guide investment decisions as well as independent financial
institutions to ensure that capital was allocated efficiently. For example
basic banking regulation such as capital adequacy ratios did not even exist.
Banks were controled by the chaebols, either directly or indirectly through
shares held by securities companies, merchant banks and insurance firms
affiliated with the chaebols. Hostile take- overs, mergers and acquisitions
were not allowed. Capital formation was funded by borrowing. This raised
the debt to equity ratio to around 400% in 1997 (519% for the thirty largest
chaebols).
The corporate sector was caracterized by low profitability and the tendency
to invest in long term capital intensive investment using short term capital
loans. Since 1993 Korean enterprises were allowed to borrow directly from
abroad to finance imports of capital goods. This the lack of proper
prudential supervision allowed an excessive build up of short term foreign
debt far exceeding Koreas exchange reserves. This led to a massive
increase of Koreas short term foreign debt which had risen to $ 100 billion
in 1996. The short term indebtness accounted for two thirds of the total
external debt of $ 150 billion in 1997. In other words the system
encouraged excessive risk taking and insufficient attention to credit and

89
exchange rate risk taking. This too big to fail mentality created a serious
moral hazard and made Korea susceptible to the Asian contagion in 1997.
Terms of trade shock
Secondly Korean firms endured a terms of trade shock in 1996 and 1997 as
a result of an increase of Chinese competition in industrial products and of
the collapse of semiconductor prices. Overall export prices dropped by 13 %
in 1996 and by another 17% in 1997. Faced with a fall of operating income
and rising financial costs ( following the rise of US rates of interest) the
corporate net income turned negative in 97. Many chaebols went bankrupt.
This in turn spilled over to the banking sector. Non performent loans of
commercial banks rose. Inadequate loan losses provisions deteriorated
banks financial health. The lack of transparency of the banking system rules
contributed to the loss of confidence of investors in the Korean financial
market : it has been said that in 1997 the authorities did not know the
amount of the foreign debt.

Development
In July 1997 the stock exchange began to drop. In the wake of the Asian
market downturn investors got rid of their Korean assets in order to
compensate for their losses on the Tha and other financial markets.
The impact of the crisis was severe. In the first half of 98 private
consumption fell by 11%, imports by 26% and investment in fixed capital
(machinery and equipement ) by 42%. The number of unemployed tripled to
1.5 million in 98.

90

Aftermath and recovery

The Korean economy achieved a quick recovery in the first half of
99.Output increased by 7%, employment growth resumed and the exchange
rate remained steady. For factors explained the strength of this recovery.
1)

Reforms

Firstly the commitment of the government to reform never waved . Four

ranges of structural reforms were implemented in 1998-1999 : a reform the
financial institutions, a reform of the rules of competition, a restructuring of
the industrial sector and a reform of the labour market.
a)

Rescuing insolvent financial institutions and introducing a new system

of financial supervision.
During the crisis more than 100 financial institutions were closed. In order
to rescue the viable ones the government launched a major programme,
providing 64 trillion won (14% of GDP), by the recapitalisation of banks
and the purchase of non performing loans. Banking supervision was brought
closer to the international standards. A prompt corrective action system was
introduced which requires actions when risk indicators fall below specific
thresholds.
b)

Re-enhancing the competitiveness of the Korean corporate sector.

Significant changes have been introduced in order to bring business

conditions in line with international best practices. Transparency has been
introduced through the mandatory financial statements of the large chaebols.
Accounting practices were brought closer to the international standards.
The five main chaebols agreed in december 98 to reduce their debt to equity
to below 200%. Companies who failed to reach this objective by the end of
99 risked being refused further credit by the banks.

91

c)

Restructuring the industrial sector

In the core industries ( semiconductors, oil refineries, ship engines , railroad

vehicles, cars , petrochemicals) the government encouraged greater
concentration and reduction of excess capacity.This market concentration
re-enhanced Koreas industry competitivity through economies of scale
though there is the risk of collusion following the increase in market
concentration, the number of producers in each sector being reduced to one
or two. A competition regulatory reform was launched which eliminates in
principle all anti-competitive regulations.
d)

Increasing labour market flexibility

Labour laws were revised in february 98 in order to enhance labour market

flexibility particularly by the possibility to employ temporary workers up
for two years. At the same time unemployment insurance was expanded. In
order to re-employ the redundant workers a large-scale public works
program was established.
2)

Monetary policy

Devaluation of the won , an American rescue package of billion $ and the

collapse of imports facilated the balance of payments recovery and the
replenishment of foreign reserves. This in turn facilated the easing of
monetary policy. Peaking at more than 30% in 1997, interest rates began to
fell in 1998 (20%) and reached 5% in 1999.

3)

Budgetary policy

92
Government expenditure increased : 10 trillion won ( 2.5% of GDP) were
spent on fighting unemployment and in rehabilating the financial sector.
Since the crisis reduced fiscal receipts, the budgetary deficit increased to 3%
of GDP. This boosted final demand and helped recovery.The budget deficit
was funded by debt which rose from 11% to 19% of GDP.
4)

Exports

Devaluation had a beneficial impact on exports which grew at an impressive

rate of 13% in 1998. Korea had favorable external conditions as the
Japanese yen appreciated . Renewed strong demand for semi-conductors
boosted output.

Korea
Main Macroeconomic Economic Indicators

93

1995

1996

1997

1998

1999

Rate of exchange

won/$

771

804

951

1401

1188

Current Account

Billion $

-8,6

-23,2

-8,3

40,3

24,5

Capital Account

Billion $

-0,4

-0,5

-0,6

0,1

-0,3

Financial Account

Billion $

17,2

24

-9,1

-8,3

12,7

Overall Balance

Billion $

1,4

-22,9

25,9

33,2

Budgetary balance

Million
Won

1711

110

-69

-13216

-15512

M3

Billion
Won

153946

178312

203532

258538

329317

8,8

11,8

15,2

9,4

82,3

86,3

90,2

97

97,7

2,5

6,8

6,2

80,7

86,3

90,3

84,1

92,1

Lending rate
Consumer Prices

2000 =
100

Unemployment rate
GDP volume

2000 =
100

Source : IMF

Bibliography

94
Agnord P-R The Economics of Adjustment and Growth Harvard University Press,
2eme d. 2004.
Desai P. Financial crisis, contagion and containment : from Asia to Argentina
Princeton University Press 2003.
Eichengreen B. Financial crisis Oxford University Press 2002
Grellet G. Les Politiques Economiques des Pays du Sud P.U.F. 1992
Hossein A. et Chowdhury A. Open Economics for Developing Countries Edward
Elgar 1998
IMF World Economic Outlook annuel

Krugman P. ed., Currency crises The University of Chicago Press 2000.

Lustig N., Life is not easy : Mexico quest for stability and growth Journal of
Economic Perspectives , vol.15, n1, 2001, pp 85-106.
Miskin F. Global Financial Instability : Framework, Events, Issues Journal of
Economic Perspectives , vol.13, n4, 1999.
OCDE Economic survey of Korea (1996, 1998,1999, 2000)
Stiglitz J.E., Lessons from East Asia Journal of Policy Modeling, n3, pp.311-330.
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Stiglitz J.E. et alii Stability with Growth Oxford University Press 2006.

Sites internet

95

www.worldbank.org
www.imf.org
www.jedh.org ( joint external debt hub : donnes sur lendettement extrieur partir de
2003)
www.bis.org ( site de la banque des rglements internationaux ; renvoie aux sites des
banques centrales)