Case study on developing

country borrowing and debts

Group 5
 TABLE OF CONTENTS
01 Developing countries, 02 The risks of foreign
foreign borrowing borrowing in
and debts developing countries

03 Debt defaults and

Latin America Crises
in1980s and 1990s
1. Developing countries, foreign
borrowing and debts
Economics of financial inflows to developing countries
S - I = CA
Reason for borrowing of developing countries:

Low national saving due to poverty and poor financial

institutions

Poor in capital -> opportunity for profitability from raising

capital => Borrow aboard

Borrowers and lenders still profits from productive investments

which can’t be carried out .

Acceleration of debt: Loans are not always justified Loans that

finance unprofitable investments Faulty government policies
The problem of defaults

Definition: Default occurs when the borrower,

without the agreement of the lender, fails to repay on
schedule according to the loan contract.
:Explanation of defaults
- CA deficit -> foreign lenders fear default and cut off
all new loans -> sudden stop
- To reach positive CA -> combination of a fall in
investment or a rise in saving -> decreases AD and Y ->
default
- Foreign lenders demand full repayment on short-
term loans => The bigger the country’s short-term
foreign debt, the larger the rise in saving or
compression of investment needed to avoid a default.
Types of defaults:
- Sovereign default (government) vs private
default (private firms)
- In practice in developing countries, the two
types of default go together
=> Government becomes closely involved in the
subsequent negotiations with foreign creditors.
Alternative Forms of Financial Inflow

Debt Finance Equity Finance

Foreign direct investment (FDI)Portfolio
Bond finance Bank finance Official lending
investment in ownership of firms
Foreigners have a claim to a share of the
The debtor must repay the loan + interest,
investment’s net return -> dependent on host
regardless of its own economic
countries’ economic condition=> less risky
circumstances.
for developing countries
The risks of foreign
borrowing in developing
countries
 Original sin
- When developing countries incur debts to foreigners,
those debts are overwhelmingly denominated in
terms of a major foreign currency: the US dollar, the
euro, or the yen. In contrast, richer countries typically
can borrow in terms of their own currencies.

- When a local currency devaluation occurs in the US,

Japan or the EU, the debt obligations are priced in the
same local currency, but the value of the foreign
assets increases. A devaluation of the domestic
currency increases the value of net foreign wealth.
 Debt crisis
Income will decrease and interest rates will increase,
making the repayment capacity of both government
and private sector increasingly more difficult.

High interest rates

Low income

The tightening of austerity to repay the debt can cause

the economy to decline more seriously.
If the central bank is implementing a fixed
exchange rate regime, it can lead to a
currency crisis. Because when foreign
exchange reserves are exhausted, the ability
to protect the exchange rate will decrease.
 Banking crisis

Depositors will quickly

withdraw money (and can
buy foreign currency),
pushing the bank into an
easier position of
bankruptcy
Therefore, a debt crisis, a currency crisis
and a banking crisis can occur at the
same time, and one crisis can aggravate
the other. Besides, each crisis has the
effect of reducing aggregate demand
and output and jobs are more serious.
Debt defaults and Latin America Crises in 1980s
and 1990s
 3.1. The Debt Crisis of the
1980s:
- The great recession of the early 1980s sparked a crisis
over developing-country debt

- The results were a widespread inability of developing

countries to meet prior debt obligations and a rapid
move to the edge of a generalized default.

- The crisis didn’t end until 1989 when the United States,
fearing political instability to its south, insisted that
American banks give some form of debt relief to
indebted developing countries. When Argentina and
Brazil reached preliminary agreements with their
creditors in 1992, it looked as if the debt crisis of the
1980s had finally been resolved.
3.2. Reforms, Capital Inflows, and
the Return of Crisis:
Argentina
- Argentina turned to radical institutional reform
in the early 1990s. Argentina’s plan had a
dramatic effect on inflation

- As the world economy slipped into recession

in 2001, Argentina’s foreign credit dried up.
The country defaulted on its foreign debts in
December 2001 and abandoned the
peso/dollar peg in January 2002. The peso
depreciated sharply and inflation soared once
again.
 Brazil
- In 1994, the Brazilian government
introduced a new currency, the real,
pegged to the dollar.

- In January 1999, Brazil devalued the

real by 8% and then allowed it to float.
Very quickly, the real lost 40% of its
value against the dollar. Recession
followed as the government struggled to
prevent the real from going into a free
fall. But the recession proved short-
lived, inflation did not take off, and
financial-sector collapse was avoided.
 Chile
- Chile instituted a tough regulatory environment for
domestic financial institutions and removed an
explicit bailout guarantee

- The Chilean central bank was made independent

of the fiscal authorities in 1990

- Another new policy required all capital inflows

(other than equity purchases) to be accompanied
by a one-year, non-interest-bearing deposit equal
to as much as 30% of the transaction.

- Between 1991 and 1997, the country enjoyed GDP

growth rates averaging better than 8 % per year. At
the same time , inflation dropped from 26% per
year in 1990 to only 6% by 1997.
 Mexico
- Mexico fixed its peso’s exchange rate against the U.S. dollar at the end
of 1987, moved to a crawling peg at the start of 1989, and moved to a
crawling band at the end of 1991.

- During 1994, the country’s foreign exchange reserves fell to very low
levels. The new Mexican government devalued the peso 15%

- The devalued currency peg was immediately attacked by speculators,

and the government retreated to a float, default loomed again. The
country avoided disaster only with the help of a $50 B emergency loan
orchestrated by the U.S. Treasury and the IMF.

- By 1996, inflation was falling and the economy was recovering as the
peso continued to float. Mexico regained access to private capital
markets and repaid the U.S. Treasury ahead of schedule.
Thanks for listening
Group 5