Chapter 21
International Lending and Financial Crises
Overview
International capital movements can bring major gains both to the lending or investing countries
and to the borrowing countries, through intertemporal trade and through portfolio diversification
for the lenders/investors. But international lending and borrowing sometimes is not well-behaved
—financial crises are recurrent. This chapter examines both the gains from well-behaved lending
and borrowing and what we know about international financial crises.
We begin with the economic analysis of international capital flows that focuses on the stock of
wealth of two countries and how that wealth can be lent or invested in the two countries. With no
international lending, the country that has much wealth relative to its domestic investment
opportunities will have a lower rate of return or interest rate. Freeing international capital flows
permits the low-rate country to lend to the high-rate country. As the world shifts to an
equilibrium with free capital movements, both countries gain. As usual, however, within each
country there are groups that gain and groups that lose from the international lending.
We can also use this analysis to show that either nation could gain by imposing a small tax on the
international capital flows, because it could shift the pre-tax foreign interest rate in its favor.
Either country could seek to impose a nationally optimal tax, but this works well only if the other
country does not impose a comparable tax.
International lending and borrowing often is well-behaved, but not always. The chapter next
examines financial crises in developing countries during 1982 to 2002. Following defaults in the
1930s, lending from industrialized countries to developing countries was low for four decades.
Such lending dramatically increased in the 1970s for four reasons. First, oil-exporting countries
deposited large amounts of petrodollars in banks following the increases in oil prices. Second,
the banks did not see good prospects for lending this money to borrowers for capital spending in
the industrialized countries. Third, developing countries resisted foreign direct investment from
multinationals based in the industrialized countries, so increased capital flows to the developing
countries took the form of bank loans to these countries. Fourth, herd behavior among banks
increased the total amount lent to developing countries.
Crisis struck in 1982, when first Mexico and then many other developing countries declared that
they could not repay. The crisis was brought on by rising interest rates in the United States,
which raised the cost of servicing the loans, and declining export earnings for the debtor
developing countries, as the industrialized countries endured a deep recession. This debt crisis
wore on through the 1980s. Beginning in 1989, the Brady Plan led to reductions in debt and
conversion to bonds. By 1994, the 1980s debt crisis was finally over.
Beginning in about 1990 lending to developing countries began to grow rapidly. Low U.S.
interest rates led lenders and investors to seek out better returns elsewhere, and many developing
countries became more attractive as places to invest by shifting to more market-oriented policies.
In addition, individual investors and fund managers began to view developing countries as
emerging markets for financial investments.
Still, the 1990s were punctuated by a series of financial crises. In late 1994 a large current
account deficit, a weak banking system, and rapid growth in dollar-indexed Mexican government
debt (tesobonos) led to a large devaluation and depreciation of the Mexican peso and a financial
crisis as foreign investors refused to buy new tesobonos. Contagion (the “tequila effect”) spread
the crisis to other countries. A large rescue package offered mostly by the U.S. government and
the International Monetary Fund (IMF) contained the crisis and the contagion.
The Asian crisis of 1997 hit Thailand first and then spread to Indonesia and South Korea, as well
as Malaysia and the Philippines. The problems differed somewhat from one country to another,
but one cause of the crisis was weak government regulation of banks, so that the banks borrowed
large amounts of foreign currency, and then lent these funds to risky local borrowers. In addition,
the growth of exports generally was declining for these countries, leading to some weakness in
the current account.
Russia was not much affected directly by the Asian crisis, but it had a large fiscal deficit and the
need for large borrowing by the government. By mid-1998 foreign lenders reduced their
financing, and an IMF loan foundered when the Russian government failed to enact changes in
its fiscal policy. In the face of rising capital flight, the Russian crisis hit, as the Russian
government allowed the ruble to depreciate and defaulted on much of its debt. With no rescue
from the IMF, foreign lenders and investors suffered large losses. They reassessed the risk of
lending to developing countries, and flows of capital to developing countries declined for the
year.
Argentina pegged its peso to the U.S. dollar and succeeded in ending its hyperinflation in the
early 1990s. However, the peso experienced an increase in its real effective exchange rate value,
and an extended recession began in 1998. The fiscal deficit widened, and the IMF stopped
lending to it in late 2001. In early 2002 the government ended the pegged exchange rate and the
peso lost three-fourths of its value relative to the U.S. dollar. The banking system largely ceased
to function and the economy went into a severe recession. After a few months delay Argentina’s
crisis spread to neighboring countries, especially Uruguay.
Based on a survey of studies of financial crises in developing countries, the chapter discusses
five reasons why they occur or are as severe as they are. The explanations have a common theme
—once foreign lenders realize that there is a problem, each has an incentive to stop lending and
to try to get repaid as quickly as possible. If the borrower cannot immediately repay, a crisis
occurs.
The first explanation is overlending and overborrowing. This can occur when the government
borrows and guarantees private borrowing, and lenders view this as low risk. The box on “The
Special Case of Sovereign Debt” uses a benefit-cost analysis to show when a sovereign debtor
would default. The Asian crisis showed that overlending and overborrowing could occur with
private borrowers as well, especially if rising stock and land prices show high returns until the
bubble bursts. The second explanation is exogenous shocks—for instance, a decline in export
prices or a rise in foreign (often U.S.) interest rates—that make it more difficult for the borrower
to service its debt. The third is exchange rate risk. This can be acute if private borrowers use
liabilities denominated in foreign currency to fund assets denominated in local currency, betting
that the exchange rate value of the local currency will not decline (too much). If it does,
borrowers attempt to hedge their risk exposure, putting further downward pressure on the
exchange-rate value of the local currency, and then they may be forced to default if the local
currency is depreciated or devalued more, before they can fully hedge their risk exposures. The
fourth explanation is a large increase in short-term debt to foreigners. The risk is that short-term
debt denominated in foreign currency cannot readily be rolled over or refinanced.
The first four explanations indicate why a financial crisis can hit a country. The fifth explanation
—contagion—indicates why a crisis in one country can spread to others. Contagion can be
herding behavior by investors, perhaps fed partly by incomplete information on other countries
that might have problems similar to those of the crisis country. Contagion can also be based on a
new recognition of real problems in other countries, with the crisis in the first country serving as
a “wake-up call.”
When a financial crisis hits a developing country, two major types of international efforts are
used to help resolve it. First, a rescue package, often led by an IMF lending facility, can be used
to compensate temporarily for the lack of private lending, to try to restore lender confidence, to
try to limit contagion, and to induce the government of the borrowing country to improve its
macroeconomic and other policies. While the Mexican rescue in 1994 was very successful in
helping Mexico weather the crisis, the rescue packages for the Asian crisis countries were only
moderately successful. A key question is whether the rescue packages increase moral hazard, so
that future financial crises become more likely because lenders lend more freely if they expect to
be rescued. The Mexican rescue probably increased moral hazard, with mixed effects from the
Asian rescues. The lack of a rescue for Russia reduced moral hazard as lenders lost substantial
amounts with no rescue package implemented. (The box “Short of Reserves? Call
1-800-IMF-LOAN,” another in the series on Global Governance, describes the IMF’s lending
activities and its use of conditionality.)
Second, debt restructuring (rescheduling and reduction) is used to create a more manageable
stream of payments for debt service. Restructuring can be difficult because an individual lender
has an incentive to free ride, hoping that other creditors will restructure while demanding full
repayment as quickly as possible for its own loans. The Brady Plan overcame the free rider
problems to resolve the debt crisis of the 1980s. During the debt crises of the 1990s, it was
relatively easy to restructure debt owed to foreign banks. A new problem was the great difficulty
of restructuring bonds, because the legal terms of most bonds gave powers to small numbers of
bondholders to resist restructuring. The shift to bonds that include collective action clauses
should reduce this problem.
We now are paying more attention to finding ways to reduce the likelihood or frequency of
financial crises in developing countries. Some proposals for improved practices in borrowing
countries, including better macroeconomic policies, better disclosure of information and data,
avoiding government short-term borrowing denominated in foreign currencies, and better
regulation of banks, enjoy widespread support. Other proposals are controversial, with experts
sometimes pointing in opposite directions. Developing countries should shift to relatively cleanly
floating exchange rates, or they should move to rigid currency fixes through currency boards.
The IMF should have access to greater amounts of resources so it can help countries fight off
unwarranted financial attacks, or the IMF should be abolished to reduce moral hazard. The text
looks more closely at two proposals for reform, the need for better bank regulation, and the
controversial proposal that developing countries should make greater use of capital controls to
limit capital inflows, and especially to limit short-term borrowing.
Financial crises also hit industrialized countries, and the chapter concludes with an examination
of the global financial and economic crisis. The crisis began in the United States, which had
experienced a credit boom and a bubble in house prices. As the house price bubble began to
deflate in 2006, an increasing number of mortgages went into default. In August 2007 problems
at BNP Paribas signaled the depth of losses on securities backed by these mortgages.
Furthermore, financial institutions became reluctant to lend to each other, because potential
lenders became worried that the borrowing institutions may hold dodgy assets that made it more
likely that they could not service their debts in the future. With the failure of Lehman Brothers in
September 2008, short-term financial markets and lending among financial institutions froze, and
the crisis entered a much worse phase. The U.S. Federal Reserve and other central banks
responded with efforts to inject liquidity and shore up financial institutions and markets. By late
2009 most financial markets were operating reasonably well. The chapter concludes with an
examination of how the causes of the global crisis are in several ways similar to the causes of
crises in developing countries.
The box “National Crises, Contagion, and Resolution,” in the new series on the euro crisis,
discusses how the euro crisis was three interlocking crises (sovereign debt, banking, and
macroeconomic) that fed on each other.
Tips
Many students have a keen interest in international lending and investing and financial crises.
This chapter can also readily be supplemented with readings from recent press articles on
developments (e.g., in Greece or in Italy) in the aftermath of the euro crisis.
The first section or two of this chapter on the gains from international capital flows and the
taxation of international capital flows can be assigned and covered in conjunction with the
material of Chapters 2-15 (especially the analysis of direct investment and migration in Chapter
15).
If this chapter is assigned before students read the second half of Chapter 20, the instructor may
want to assign the box “The International Monetary Fund” as required reading to provide an
introduction to the organization.