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90
CHAPTER OUTLINE
I. Private foreign debt has played an important role in nancing investment in
less- developed countries. The chapter begins by noting the extreme volatility
of these ows: expanding and then contracting. It then discusses the advan-
tages and disadvantages of foreign borrowing. The advantages are that a coun-
try can invest more than it can save. The disadvantages include having to rely
on short- term debt, which can be quickly withdrawn.
II. The authors formalize debt sustainability by studying separately the internal
transfer problem and the external transfer problem. Debt indicators are many,
ranging from debt/GDP to debt ser vice/revenue, each with its pluses and
minuses. Debt sustainability can be formalized further with the help of an
equation that draws on the current account balance and the investment- savings
balance.
III. The composition of private debt ows shifted considerably in the 1990s with
the slack in commercial bank lending being picked up by bonds and other
short- term debt. Between 1970 and 1983, commercial bank lending to devel-
oping countries tripled in real terms. Several countries overborrowed and
were later unable to ser vice their loans when interest rates rose and industrial
countries slid into a deep recession. The text analyzes the genesis and propa-
gation of the debt repayment crisis. It also considers several instruments used
to alleviate the debt burden, including interest capitalization, rescheduling,
buybacks, and debt- equity swaps. The debt crisis largely was over by the early
1990s as the large Latin American and Asian borrowers managed to under-
take successful stabilization and structural adjustment programs, and the
world economy recovered.
Foreign Debt and Financial Crises
CHAPTER 13
Foreign Debt and Financial Crises | 91
IV. The debt crisis in low- income countries requires a par tic u lar approach. Due
to the debt overhang, many of these countries are constrained from growing
because their resources are spent to repay debt. The heavily indebted poor
countries (HIPC) initiative launched by the World Bank and IMF was formed
to coherently address this issue. Countries must develop poverty reduction
strategy papers so that they can reach decision points and completion points to
have their debt reduced. As the program was conducted until 2009, countries
that reached the completion point received a debt reduction suf cient to reduce
their NPV/debt/export ratio to 150 percent, a level the IMF and World Bank
deem to be the threshold for sustainable debt for low-income countries.
V. Worrisome changes emerged in the size and maturity structure of short- term
capital ows during 1990s. Short- term debt and portfolio equity ows accounted
for more than one- fourth of total private ows, especially to emerging mar-
kets. The chapter discusses how a combination of institutional weaknesses,
macroeconomic imbalances, and self- ful lling creditor panics conspired to
produce currency crises in such emerging economies as Mexico, Argentina,
Thailand, Korea, Malaysia, Indonesia, and Rus sia.
Boxed Examples
Box 13– 1: A Short History of Sovereign Lending Default
Box 13– 2: Odious Debt
Box 13– 3: Debt Relief in Uganda
Box 13– 4: Model of Self- Ful lling Creditor Panics
There are four case studies. The rst summarizes the history of sovereign lending
default. The second explores the idea of odious debt, of how to treat debt that
“good” governments inherit from odious regimes. The third reviews the instruc-
tive experience of Uganda with the HIPC debt relief initiative, a donor program
that rewards reforming countries with a deep commitment to improving the deliv-
ery of public ser vices to the poorest segment of the population. The fourth explains
how creditor panics are triggered and sustained. It notes that solvent countries
sometimes nd it dif cult to borrow suf cient foreign exchange if creditors
believe, rightly or wrongly, that other creditors are likely to exit.
In the New Edition
This chapter has been updated from the sixth edition to provide the most recent
data on foreign debt and provides current examples of nancial crises (including
the 2010– 2011 Euro Zone crisis). However, the overall focus remains on nancial
issues dealing with developing countries.
92 | Chapter 13
Class Notes
Chapter 13 deals with important links between developing and developed coun-
tries. The subject matter has been a source of controversy. Moreover, many stu-
dents have an intrinsic interest in nancial markets. For all these reasons, this
material is enjoyable to present in class. The fundamental story is that foreign
savings in any form can bene t the recipient host country if it manages the
resources and its economic policies prudently. Each form of foreign capital ow,
however, has distinct advantages and disadvantages that you may probe with
varying degrees of depth and emphasis. A good exercise is to obtain macroeco-
nomic indicators from a par tic u lar country either before the Asian crisis or more
recently and gauge whether the country is in danger of losing its private capital.
Two topics are technical: a quantitative treatment of rational panics and the
formal treatment of conditions for sustainable foreign borrowing, with reference
to both the trade gap and the savings- investment gap. These are important parts
of the story and ne examples of applied economics.
While this chapter mentions the need for macroeconomic stabilization and
structural adjustment, these issues are treated in much greater detail in Chapter
15, “Managing Short- Run Crises in an Open Economy.”
QUESTION BANK
Concept Map
Foreign Debt and Financial Crises
Advantages and Disadvantages of Foreign Borrowing
Debt Sustainability
Debt Indicators
A Short History of Sovereign Lending Default
Impact on the Borrowers
The Debt Crisis in Low- Income Countries
Debt Reduction in Low- Income Countries
The Heavily Indebted Poor Country Initiative
Emerging Market Financial Crises
Domestic Economic Weaknesses
Foreign Debt and Financial Crises | 93
Multiple- Choice Questions
1. The economic impact of debt ows is magni ed by their effect on all of the
following EXCEPT:
a. macroeconomic stability.
b. the exchange rate.
c. World Bank transparency.
d. government bud gets.
2. From a national perspective, borrowing permits a country to invest more
than it can save and:
a. import more than it can export.
b. engage in the pattern of “infant industry” development.
c. export more than it imports.
d. acquire more prestige in international bond markets.
3. Foreign borrowing is consistent with development when:
a. the additional investment and imports are put to productive use.
b. it increases total imports.
c. it increases total savings.
d. a country can afford the debt ser vice payments.
4. At the simple level, a country’s debt sustainability depends on:
a. its foreign exchange rate and openness to trade.
b. how much it owes and its capacity to make the required payments.
c. potential for facing adverse weather conditions.
d. willingness to devaluate its currency.
5. The amount due for principal and interest payments in a given year is known as:
a. total revenue.
b. economic pro t.
c. debt ser vice.
d. redundancy.
6. Which of the following is NOT used as a debt sustainability indicator?
a. NPV/GDP
b. debt/exports
c. short- term foreign debt/foreign exchange reserves
d. number of illiquid borrowers
7. The debt crisis of the 1980s saw a return to this problem that had been com-
mon in the nineteenth century:
a. a military action against a neighboring country to stimulate the economy.
b. sovereign defaults.
c. leftist revolutions throughout the developing world.
d. the return to Corn Laws.
8. From 1980– 1982, private creditors provided more than $50 billion a year in
new lending to developing countries; by 1987, the net resource ow was:
a. $1 billion.
b. $559 million.
c. $125 million.
d. practically zero.
9. Although the debt crisis effectively ended in the early 1990s for most middle-
income countries that had borrowed heavily from commercial banks, it con-
tinued for many low- income countries, especially those in:
a. the Middle East.
b. East Asia.
c. Latin America.
d. Africa.
10. Individual creditor governments provide debt rescheduling and debt reduc-
tion through an informal group called the:
a. G-7.
b. United Nations.
c. Paris Club.
d. Club of Rome.
11. The argument for providing debt relief for the poorest countries relies on the
idea:
a. of debt overhang.
b. that creditor governments and institutions are to blame.
c. that much was lent to poorly governed regimes.
d. all of the above.
12. The rst step for a country to receive debt reduction in the HIPC initiative is to:
a. write a poverty reduction strategy paper.
b. establish a track record of good economic policies.
c. carry out speci c policies for three years.
d. double its growth rate.
13. Common characteristics of countries caught in the Asian crises include which
of the following?
a. middle and upper- middle national incomes
b. receipt of large ows of private international capital
c. large government bud get de cits
d. all of the above
14. Assume that, as was the case in 1994, Mexican goods are 22 percent more
expensive than U.S. goods. If capital markets are fully liberalized and the Cen-
tral Bank of Mexico is committed to a pegged peso/dollar exchange rate, then:
a. foreign investors are likely to perceive this as an overvaluation of the peso.
b. there is likely to be a net out ow of short- term capital.
c. the central bank likely will need to raise interest rates.
d. all of the above.
15. Fixed exchange rates create problems because they:
a. tend to encourage short- term capital in ows.
b. tend to be undervalued.
c. create instability among investors.
d. all of the above.
96 | Chapter 13
IDs and Paired- Concept Questions
These terms can be used individually as short- answer identi cation questions, or
they can be used in pairs. In the latter case, ask students to explain (1) the meaning
and signi cance of each of the two terms and (2) the relationship between them.
2. Insolvent borrower, illiquid borrower
4. Liquidity, solvency
6. Rational panics, bank runs
8. Brady plan, Brady bonds
10. Moral hazard, standstill
12. Default, debt restructuring
