Sawyer/Sprinkle Chapter 21 Capital Flows and the Developing Countries C h a p t e r XXXXXXXXXX To accompany International Economics, 3e by Sawyer/Sprinkle PowerPoint slides created by Jeff Heyl...

Sawye
Sprinkle Chapter 21
Capital Flows and
the Developing Countries
C h a p t e r XXXXXXXXXX
To accompany
International Economics, 3e by Sawye
Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
21 – ‹#›
CHAPTER ORGANIZATION
Introduction
Capital Flows to Developing Countries
Exchange Rate Shocks
The IMF and Developing Countries
Summary
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Financial/capital account transactions affect economic development
There are reasons for the movement of capital from developed to developing countries
There are different forms such flows can take
The most common problem associated with capital flows is the sudden depreciation of the cu
ency of a developing country and there are macroeconomic consequences of these types of depreciations
The IMF plays a controversial role in this
INTRODUCTION
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Capital tends to flow from the developed to the developing countries because of differences in factor abundance
Developing countries tend to run cu
ent account deficits that are offset by capital/financial account surpluses
This means that the developing countries are bo
owing from the developed countries
In many cases the developing country is a net debto
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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Conceptually, there is not a problem with this bo
owing as long as the capital is used productively
Sadly, bo
owing by governments in developing countries has a checkered history
The form that this bo
owing takes is important
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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Debt Versus Equity
Bo
owing by developing countries takes the form of either debt or equity
Payments on debt have to be made at certain points in time no matter what the economic condition of the bo
ower is
Debt refers to bo
owing by countries in the form of 1)bonds or 2)bank loans or 3)bo
owing from developed country governments
Loans from commercial banks are refe
ed to as sovereign loans
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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Equity is the situation where the lender is also an owner in the company or project being financed
This is commonly FDI or the movement of portfolio capital between countries
Debt payments have to be made on the due date no matter the condition of the bo
owe
Equity are much more tied to cu
ent economic conditions and owners do not normally have a right to fixed payments
They have a claim on all or part of the firm’s assets
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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CAPITAL FLOWS TO DEVELOPING COUNTRIES
Table 21.1    Capital Flows to Developing Countries
    Country Group    Net Private Capital Flows    Foreign Direct Investment    Portfolio Investment Flows        Bank & Trade Related Lending
                Bonds    Equity    
    Developing Countries    $121,790    $280,795    $55,110    $66,680    $81,134
    Low-income Countries    10,327    20,522    –2,144    12,471    3,902
    Middle-income Countries    111,463    260,273    57,254    54,209    77,231
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CAPITAL FLOWS TO DEVELOPING COUNTRIES
Table 21.2    External Debt of Developing Countries
    Country Group    Total External Debt    Long-term Debt    Public & Publicly Guaranteed Debt    Private External Debt    Use of IMF Credit
    Developing Countries        $2,742,378    $2,147,179    $1,361,634    $785,545    $49,179
    Low-income Countries    379,239    338,595    298,209    40,385    8,322
    Middle-income Countries    2,363,139        1,808,585    1,063,425    745,160    40,857
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Most flows of debt and equity are relatively small
The majority of these flows are investments made by companies in land, plants, and equipment in middle-income countries
These are long term investments and represent the confidence investors have in the economic potential of these countries
One possible difficulty is the ability of developing countries to make timely payments on their debt
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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Servicing Foreign Debt
The foreign debt of the developing countries has to be repaid over time
For most developing countries, foreign debt cannot be repaid in domestic cu
ency and foreign exchange must be available
Foreign reserves are the total stock of foreign exchange held by a country at any point in time
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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If this level is extremely low, then a country may face the uncomfortable choice of imports versus debt repayments as there might not be enough foreign exchange for both
The debt/export ratio is the ratio of a country’s debt payments to its exports
This ratio expresses the amount of debt repayment a country must make in relation to its export earnings
Countries need an adequate supply of foreign reserves to make prompt debt payments
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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Foreign debt will be easier to service if the debt/export ratio is relatively low
Putting the above two concepts together, one can get a picture of a country that can afford to take on more debt
A country may be in default if it cannot simultaneously pay all its debts
This does not mean that the country is bankrupt. It only means that it cannot cu
ently repay all creditors
This might trigger a major depreciation of the exchange rate
CAPITAL FLOWS TO DEVELOPING COUNTRIES
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Exchange rate shocks occur if there is a sudden shift in either the demand for or the supply of foreign exchange
Any combination of a decrease in the supply of foreign exchange and/or an increase in the demand for foreign exchange would cause the exchange rate to increase and the domestic cu
ency to depreciate (from point A to D)
Any combination of an increase in the supply and/or a decrease in the demand would cause the exchange rate to fall (from point D to A)
EXCHANGE RATE SHOCKS
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EXCHANGE RATE SHOCKS
Figure 21.1    External Debt of Developing Countries
Exchange Rate (XR)
XR’
XR
FX
FX’
Foreign Exchange (FX)
A
B
C
D
S
S’
D
D’
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Macroeconomic Consequences of Exchange Rate Shocks
A sudden depreciation is generally the most troublesome for the domestic economy
An exchange rate increase causes a decrease in aggregate supply and an increase in the cost of imports (from Ch17)
The overall cost of production in the economy rises
EXCHANGE RATE SHOCKS
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The price level increases and real GDP declines
The larger the depreciation, the larger the effects on the price level and real GDP
In the short-run, an extremely large depreciation can have substantial effects on the domestic economy
This macroeconomic environment has serious consequences for developing countries
Many developing countries lack the social safety nets to help to cushion the economic blow
EXCHANGE RATE SHOCKS
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EXCHANGE RATE SHOCKS
Figure 21.2    The Effect of an Exchange Rate Shock on the Economy
Price Level (P)
P’
P
Y
Y’
Real GDP (Y)
A
B
AS
AS’
AD
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Sources of Exchange Rate Shocks
Exchange rate shocks are more prevalent in developing countries and are a function of economic conditions that are common in low- and middle-income countries
EXCHANGE RATE SHOCKS
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Commodity Price Shocks
If a country is a major exporter of a primary commodity, then changes in commodity prices can cause exchange rate shocks
For many developing countries, the production of one or more primary commodities composes a substantial portion of exports (from Ch11)
Further, exports and imports typically represent a significant portion of the GDP
EXCHANGE RATE SHOCKS
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If the price of a particular primary commodity falls dramatically in world markets, the immediate effect would be a large reduction of inflows of foreign exchange (a leftward shift from S to S’ in Fig.21.1)
The exchange rate would increase and the domestic cu
ency would likely depreciate
The price level would rise and the real GDP would fall leading to inflation and higher unemployment (as in Fig21.2)
The reverse would be true if the commodity price level rises
EXCHANGE RATE SHOCKS
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These examples illustrate the advantages and disadvantages of exporting primary products
The economy at times can grow rather fast
Exports can also create a difficult macroeconomic environment
For countries that export primary commodities, the management of foreign reserves is a very important tool for stabilizing the economy
EXCHANGE RATE SHOCKS
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EXCHANGE RATE SHOCKS
Figure 21.3    The Impact of Dutch Disease on Exports
Exchange Rate (XR)
XR’
XR
FX
FX’
Foreign Exchange (FX)
S
S’
D
FX”
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Exchange Controls
In Fig.21.4, assume the government desires an exchange rate at XR’
There will be a shortage of foreign exchange
One way to deal with this shortage of foreign exchange is through exchange controls where the government becomes a monopolist and rations foreign exchange
If the economy and demand for foreign exchange is growing but the supply of foreign exchange is growing at a slower rate or declining, the cu
ent account deficit may be growing
EXCHANGE RATE SHOCKS
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EXCHANGE RATE SHOCKS
Figure 21.4    Effects of Exchange Controls
Exchange Rate (XR)
XR’
XR
FX
Foreign Exchange (FX)
S
D
B
A
C
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The fixed exchange rate may have to change
Export earnings may become so low relative to the demand that the country cannot pay for essential imports such as food, fuel, and intermediate goods
The exchange rate may have to increase by a large amount in a short period of time
The price level would rise and real GDP would fall (a leftward shift of AS curve in Fig.21.2)
EXCHANGE RATE SHOCKS
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Intervention, Capital Flight, and Defaults
Intervention may be a way of avoiding the macroeconomic consequences of an overvalued exchange rate
Suppose a government pursues both expansionary fiscal and monetary policies to drive rapid economic growth
The economy may be growing rapidly but the price level may start reaching uncomfortably high levels
EXCHANGE RATE SHOCKS
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EXCHANGE RATE SHOCKS
Figure 21.5    Effects of An Expansionary Macroeconomic Policy
Price Level (P)
P’
P
Y