1. Describe how the level of foreign reserves and the debt/ export ratio affect the ability of a country to pay foreign debt.
2. Graph an exchange rate shock caused by a decrease in the supply of foreign exchange. next show how this shock affects a country's price level and real GDP.
Sawyer/Sprinkle Chapter 21 Capital Flows and the Developing Countries C h a p t e r 2 1 To accompany International Economics, 3e by Sawyer/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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 2 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 currency of a developing country and there are macroeconomic consequences of these types of depreciations The IMF plays a controversial role in this INTRODUCTION Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 3 Capital tends to flow from the developed to the developing countries because of differences in factor abundance Developing countries tend to run current account deficits that are offset by capital/financial account surpluses This means that the developing countries are borrowing from the developed countries In many cases the developing country is a net debtor CAPITAL FLOWS TO DEVELOPING COUNTRIES Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 4 Conceptually, there is not a problem with this borrowing as long as the capital is used productively Sadly, borrowing by governments in developing countries has a checkered history The form that this borrowing takes is important CAPITAL FLOWS TO DEVELOPING COUNTRIES Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 5 Debt Versus Equity Borrowing 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 borrower is Debt refers to borrowing by countries in the form of 1)bonds or 2)bank loans or 3)borrowing from developed country governments Loans from commercial banks are referred to as sovereign loans CAPITAL FLOWS TO DEVELOPING COUNTRIES Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 6 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 borrower Equity are much more tied to current 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 7 CAPITAL FLOWS TO DEVELOPING COUNTRIES Table 21.1Capital Flows to Developing Countries Country GroupNet Private Capital FlowsForeign Direct InvestmentPortfolio Investment FlowsBank & Trade Related Lending BondsEquity Developing Countries$121,790$280,795$55,110$66,680$81,134 Low-income Countries10,32720,522–2,14412,4713,902 Middle-income Countries111,463260,27357,25454,20977,231 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 8 CAPITAL FLOWS TO DEVELOPING COUNTRIES Table 21.2External Debt of Developing Countries Country GroupTotal External DebtLong-term DebtPublic & Publicly Guaranteed DebtPrivate External DebtUse of IMF Credit Developing Countries$2,742,378$2,147,179$1,361,634$785,545$49,179 Low-income Countries379,239338,595298,20940,3858,322 Middle-income Countries2,363,1391,808,5851,063,425745,16040,857 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 9 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 10 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 currency 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 11 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 12 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 currently repay all creditors This might trigger a major depreciation of the exchange rate CAPITAL FLOWS TO DEVELOPING COUNTRIES Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 13 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 currency 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 14 EXCHANGE RATE SHOCKS Figure 21.1External Debt of Developing Countries Exchange Rate (XR) XR’ XR FX FX’ Foreign Exchange (FX) A B C D S S’ D D’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 15 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 16 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 17 EXCHANGE RATE SHOCKS Figure 21.2The Effect of an Exchange Rate Shock on the Economy Price Level (P) P’ P Y Y’ Real GDP (Y) A B AS AS’ AD Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 18 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 19 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 20 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 currency 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 21 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 22 EXCHANGE RATE SHOCKS Figure 21.3The Impact of Dutch Disease on Exports Exchange Rate (XR) XR’ XR FX FX’ Foreign Exchange (FX) S S’ D FX” Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 23 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 current account deficit may be growing EXCHANGE RATE SHOCKS Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 24 EXCHANGE RATE SHOCKS Figure 21.4Effects of Exchange Controls Exchange Rate (XR) XR’ XR FX Foreign Exchange (FX) S D B A C Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 25 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 26 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 – ‹#› 27 EXCHANGE RATE SHOCKS Figure 21.5Effects of An Expansionary Macroeconomic Policy Price Level (P) P’ P Y