9. Developing Countries

Question 1

What are the structural features of developing countries?

Answer 1

1. Extensive government control
   - Restrictions on trade, government controls the large industrial firms, and there is a lot of government spending
2. High history of inflation
   - Due to low tax revenue and high tax evasion, governments had to print money
3. Weak credit institutions
   - Lack of transparency in stocks and firms
4. Natural resources make up an important part of exports
5. Corruption and Bribery
6. Currency is pegged

Question 2

What are the investment opportunities like in developing countries?

Answer 2

Although they have low savings, they have many profitable investment opportunities

Question 3

What’s the difference between debt and equity?

Answer 3

• Debt financing involves directly borrowing money
• Bank financing, bond financing, and official lending (WB+IMF)
• Equity financing involves selling shares in a company in order to make profit
• FDI, privatisation
• Investors are more likely to invest by debt financing as opposed to equity financing because it is less risky as lenders are ensured to be paid back
• The political and social instability as well as weak financial institutions makes developing countries more risk to invest in

Question 4

What’s the problem of default?

Answer 4

• Occurs when a country is unable to pay on schedule as per the loan agreement
• A crisis occurs when the country loses all access to foreign lending:
• Unemployment rises and output falls (recession)
• Lenders withhold new loans
• Lenders demand the full repayment of previous loans
• Sudden stop of financial inflow

Question 5

What is the self-fulfilling mechanism that drives economic crises?

Answer 5

1. Debt Crisis
   - Demand for borrowed money increases, supply decreases
2. Balance of Payment Crisis
   - Peg is expected to break, leading to capital flight
3. Run on Banks
   - Banks are already weak, this pushes them to their breaking point
   * These mechanisms re-enforce one another, usually leading to sovereign default

Question 6

What is the problem of original sin?

Answer 6

Countries have to borrow in dollars, not their local currency. This increases the burden of their loan obligations during a crisis as the dollar is now worth relatively more

Question 7

What are the balance sheet effect that firms face during crises?

Answer 7

1. Cost of loans goes up because the currency devalues and interest rates rise
2. Cost of intermediate goods rises because the currency devalues
3. The ability to obtain loans increases

Question 8

What’s the context of the 1980’s debt crisis?

Answer 8

• Latin American economies were growing rapidly because the prices of commodities such as crude oil were rising
• Many countries borrowed from abroad
• Many pegged their currency to the dollar
• US was facing high inflation, so the feds raised interest rates

Question 9

What happened as a result of the feds raising interest rates?

Answer 9

• The economy slows down when interest rates rise, and the feds raised them so high to the point where the economy stopped and was led into a recession
• Impacts on developing countries:
  1. Loan burden on debtors increases because interest rates increased
  2. Loan burden on debtors increased because the USD appreciated
  3. Commodity prices collapsed

Question 10

What happened in the lost decade of Latin American growth?

Answer 10

• Countries ran out of resources
• Lenders cut off loans and demanded repayment
• Generalised default: 40 countries faced financial problems
• Resolved when the US pushed banks to give some form of debt relief