Debt & Financial Crises

Perkins et al., Chapter 13 (selectively)

Naude, W. The financial crisis of 2008 and the developing

countries. UNU-Wider Discussion Paper No. 2009/01
 Outline
• Introduction
• Explaining the Asian Economic Crisis
• The global financial crisis of 2008 and
developing countries
– Impact on SA
• Lessons

2
 Introduction
Advantages and disadvantages of foreign borrowing
• Advantages
– Scarcity of capital in low income countries
– High returns in borrowing countries can make this sensible
– Easier and quicker than FDI
– Can provide buffer for shocks
• Downside
– Has to be repaid even if project goes bad
– Increases vulnerability to sudden capital withdrawals
– Problem of financing consumption through borrowing

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• String of crises with huge impact on
growth, job creation and political dynamics
e.g.
– 1980s Latin America and in low income
countries extending into the 1990s
– 1997 Asian crisis
– 2008 Global financial crisis
– Recent Eurozone debt crisis

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Explaining the Asian Economic
Crisis
• What happened
• Explanations
– IMF
– ‘Orthodox’ critics
• Problems with the IMF plan
– Unorthodox explanations
• Chang
• Wade
• Kaplinsky
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 Dimensions of the crisis
• Started Sept 1997 - collapse of Thai baht
– currency collapses
– capital outflows
– falling asset prices
– banking crises
• Impact on real annual GDP growth (year after
crisis)
– Indonesia (-13.1%)
– S Korea (- 6.7%)
– Thailand (- 10.5%)
– Compare to worst post war US recession in 2009 ( - 2.8%)
• Spread to Russia, Brazil, South Africa
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Economics of Development, 7th Edition
Copyright © 2013, W.W. Norton & Company
10
 Explanations

– Punishment for “sins”

– crony capitalism and over-expansion funded by western
banks
– “Evil speculators”

• IMF
• overheating
• overvalued pegged currencies encouraged
excessive (external) borrowing
• lack of supervision
 The IMF response

– Loans subject to conditions

– Reform of financial sector
– Improved governance, less regulation
– Fiscal policies (reduce govt. expenditure)
– Tight monetary policy
– high interest rates to keep money in the country
– Wait for confidence to return
 Problems with the IMF Plan

• IMF mistakes
• encouraged cuts in government spending
• firms too leveraged to handle high interest rates

• Affected countries unable to act

• reducing interest rates would lead to more capital
flight
 ‘Orthodox’ critics
– ‘Hard money’ types (e.g. Krugman)
– IMF caused problems by encouraging countries to
devalue - should have kept exchange rates fixed
– Krugman argued for exchange controls to break link
between exchange rate and interest rate e.g. China
– ‘Soft money’ types (e.g. Sachs)
– Should have kept interest rates low to keep economy
going
– Has some validity but currencies may have fallen more
» hyperinflation
» $ debts
 ‘Unorthodox explanations
• 1. Crisis of under-regulation (Chang)
– Macro fundamentals were basically sound but
problems resulted from:
• relaxed control of financial sector
• exchange rate management
• abandonment of investment co-ordination
2. Problems with the high debt model
(Wade)
– Characteristics of developmental state
included
– high household savings
– high corporate debt/equity ratios
– bank-firm-state collaboration in national industrial
strategy
– Could be described as ‘crony’ capitalism but
produced high growth
• although very vulnerable to shocks
– due to high debt equity ratios in situation of increased
foreign borrowing
3. Declining terms of trade (Kaplinsky)
• Changes in real economy underlie crisis
• Too much new productive capacity partly due to
state support (‘commodity manufactures’)
– entry of China (20% decline in terms of trade for LDC
manufactured exports)
– global value of memory chip sales
» 1995 $41bn
» 1996 $25bn
» 1997 $20bn
• Fall in terms of trade for basic manufacturing
relative to design, marketing, R&D was underlying
factor leading to financial meltdown
The global financial crisis of 2008
and developing countries
• Causes of the crisis
• Reaction of governments
• Effect on developing economies
• Implications for SA

18
 Causes of the Crisis
1.Destabilizing US regulatory framework
• Policy framework required/ rewarded banks and government sponsored
enterprises (GSEs - mortgage providers like Fannie Mae and Freddie Mac)
for funding selected classes of borrowers at a subsidized interest rate
• ‘Sub prime loans’ were only sustainable as long as house prices kept on
rising
• Deposit insurance at banks made them more willing to take on risk
• Regulatory agencies slow to understand new financial innovations

2.Credit rating agencies

• Helped GSEs by over-rating the securitized debt (mortgages that had been
lumped together, broken up and resold to other investors to ‘spread risk’)
• Why? Parties wanting a rating paid for their own ratings → severe conflict
of interest!
19
 Debt outstanding by the non-financial sector in the USA, 1950–2007.

Palma J G Camb. J. Econ. 2009;33:829-869

© The Author 2009. Published by Oxford University Press on behalf of the Cambridge Political
Economy Society. All rights reserved.
 Income share of the top 1% in the USA, 1913–2006.

Palma J G Camb. J. Econ. 2009;33:829-869

© The Author 2009. Published by Oxford University Press on behalf of the Cambridge Political
Economy Society. All rights reserved.
 The result
Low interest loans + inadequate risk supervision +
slight market downturn led to:
• rising US sub-prime arrears
• losses on related securitized debt
• global loss of confidence
• liquidity is hoarded and money market tightens
• banks run into funding problems
• firms cannot get funding and bankruptcies rise
• unemployment increases and demand decreases
• spreads worldwide through financial channels (stock
markets) and real channels (export demand)

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23
 G20 Communique
 
• Commitment to increase country allotments to IMF by
$250 billion to a total of $750 billion
• commitment to refrain from competitive devaluations
• commitment to encourage WTO and resuscitate the
Doha round of trade talks
• increase funding to the Multilateral Development Banks
(MDBs) to help poorest countries (especially in sub-
Saharan Africa)
• agreement in principle to a combined fiscal stimulus
package of $5 trillion by the end of 2009

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 Impact on developing countries – main channels
• Banking failures and reductions in domestic lending
– Fear of financial contagion and declines in asset prices undermining stability of
banks and leading to reduced lending
• Reduction in export earnings
– Many developing countries had based growth on exports e.g. China, India, Korea
and Malaysia
– World trade slows sharply
• Declining commodity prices after reaching record levels in 2008 e.g. platinum in SA

• Reduction in financial flows to developing countries

• Estimated $300-400 bn decline
• Fall in ODA
• Decline in private investment flows
• Trade financing
• Remittances fall
• e.g. Lesotho, Haiti and Nepal (remittances account for over 10% of GNP)
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• UN forecasts for eastern Europe and sub-Saharan Africa
were especially bad
• fears that the growth crisis would turn into a
development crisis → increases in poverty and
malnutrition
• UN: By the end of 2009 – an estimated 100-150 million
more people in poverty than if growth had continued at
its pre-crisis levels
• why the difference in performance?
• smaller countries → less fiscal stimulus, less diversification
 

 
 Looking back – the impact of the 2008-
2009 crisis
• Developing countries weathered the 2008-
09 crisis quite well
– Epicentre was in developed countries
– Financial sectors not directly affected
– Decoupling of growth rates; largest emerging
markets continued to grow
– Resilience – had learned lessons
– Fiscal expansion cushioned the blow
 Impact on SA
• Impact was larger than in many emerging
economies
– Falling commodity prices
– Macro policies countercyclical although not to a great
extent
• Slow fiscal response
• No large scale bailouts
– Exposure to developed economies, esp. Europe
– Employment fell sharply (0.75 - 1 million jobs lost)
• Recovery has been slow, especially of employment
Growth slowdown and output fall during the 2008-2009 crisis
Change in GDP growth rate from 2008 to 2009
Source: OECD
Real gross domestic product
Source SARB Annual Report , 2012
South Africa’s recovery lagged that of other emerging
markets…..
Source: IMF
And employment lagged the slow recovery….
(2008 Q4 = 100)
Source: IMF
 SA vulnerabilities
• Low growth even in the good times
• Open economy
– Vulnerable to declining commodity prices
– Europe still very important as export market and source
of investment
– Current account deficit
• The social crisis
– Inequality and unemployment already exceptionally high
– Limits to further redistribution through social grants?
• More recently – political and policy uncertainty
Q: What is our biggest vulnerability?
35
 GDP growth and unemployment: SA and Eurozone countries
10 30

8 24

6 18

Unemployment rate , 2012 (%)

GDP growth, 2011-2012 (%)

4 12

2 6

0 0
Greece Spain Germany UK South Africa

-2 -6

-4 -12

-6 -18

-8 -24

-10 -30

GDP Growth GDP Growth Unemployment rate Unemployment rate

 Lessons from the crises
• Be cautious about financial liberalisation
• Vulnerabilities of relying on fixed exchange rate
• Clear difference between long term capital
(including FDI) and short term capital
• Reduce vulnerability by limiting short term
inflows and building up foreign exchange
reserves
• Need to reform international financial
architecture

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