Developing Countries: Growth, Crisis, and Reform

Lecture 11
Chapter 22

Income, Wealth, and Growth in the World Economy

Poverty is the basic problem that developing countries face, and escaping from poverty is their
overriding economic and political challenge.
Most developing countries are poor in the factors of production essential to modern industry:
capital and skilled labor.
The Gap between Rich and Poor
 Average national income per capita in the richest economies is 76 times that of the average in
the poorest developing countries.
Has the world gap narrowed over time?
 The theory behind this observed convergence in per capita incomes is deceptively simple
“catch-up”
 If trade is free, if capital can move to countries offering the highest returns, and if knowledge
itself moves across political borders so that countries always have access to cutting-edge
production technologies, then there is no reason for international income gaps to persist for
long.
Structural Features of Developing Countries
Developing countries differ widely among themselves these days, and no single list of “typical”
features would accurately describe all developing countries.
On average, developing countries are suffering from the following:
▫ Direct Government Control of the Economy.
▫ High Inflation (due to expanding money supple consciously to extract Seigniorage).
▫ Weak credit institutions.
▫ Inefficient channeling of savings to investments.
▫ Controlled exchange rates by governments.
▫ Natural resources or agricultural commodities make up an important share of exports for
many developing countries.
▫ Corruption.
▫ Shadow economy.
Developing Countries Borrowing and Debt
• Many rely heavily on financial inflows from abroad to finance domestic investment.
• Domestic saving < potential domestic investment opportunities = S<I = Current account
deficit = debt to finance this deficit.
• Notice that when developing countries borrow to undertake productive investments that
they would not otherwise be able to carry out, both they and the lenders reap gains from
trade.
▫ Borrowers gain because they can build up their capital stocks despite limited
national savings.
▫ Lenders simultaneously gain because they earn higher returns to their savings
than they could earn at home.
▫ Sometimes debt collected by developing countries has no solid rationale behind,
like debt taken to support consumption.
• It is important to state that using debt to solve saving problems should be temporary until
enhancing the financial sector and increases savings. Debt is not a lifetime medicine.
• Developing countries could be subjected to the problem of default.
• Default when the borrower, without the agreement of the lender, fails to repay on
schedule according to the loan contract (domestic-foreign). When a government defaults
on its obligations, the event is called a sovereign default (domestic-domestic).
• Both social and political instability in developing countries, as well as the frequent
weaknesses in their public finances and financial institutions, make it much more risky to
lend to developing than to industrial countries.
• When the lending country suspects the possibility of default, they start to cut off future
loans and demand the existing ones.
• This requires developing countries to have surpluses in their current accounts to be able
to repay debt without losses, and this is never the case.
• The sudden payment of debts depends mainly on the available foreign reserves. This
means that foreign reserves are no longer available to fix the exchange rate; thus, citizens
will lose trust in the economy, and the capital will fly out of the country.
Alternative Forms of Financial Inflow for Developing Countries
Debt Finance
 Bond Finance
Developing countries have sometimes sold bonds to private foreign citizens to finance their
deficits.
 Bank Finance
Developing countries borrow from foreign commercial banks.
 Official Lending
Developing countries sometimes borrow from official foreign agencies such as the World Bank.
Equity Finance
 FDI
Firm largely owned by foreign residents acquires or expands a subsidiary firm or factory located
in the host developing country.
 Privatization
Selling to private owners large state-owned enterprises in key areas such as electricity,
telecommunications, and petroleum.
Lessons of Developing Country Crises
1980s Debt Crisis and 1990s East Asian Crisis.
Lessons Learned:
1. Choosing the right exchange rate regime.
2. Central importance of banking.
3. The proper sequence of reform measures.
4. The importance of contagion, the domino effect.