Financial Financial barriersbarriers

Three types of barriersThree types of barriers

1.1. High indebtedness of developing High indebtedness of developing countriescountries

2.2. Capital flightCapital flight

3.3. Non-convertible currenciesNon-convertible currencies

LDCs indebtednessLDCs indebtedness

IndebtednessIndebtedness is a country’s level of is a country’s level of external (or foreign) debt. It equals the external (or foreign) debt. It equals the total amount of debt (public and private) total amount of debt (public and private) incurred by borrowing from foreign incurred by borrowing from foreign creditors.creditors.

Borrowing from foreign sources is a Borrowing from foreign sources is a credit in the financial account of the credit in the financial account of the BOP and helps countries pay for deficits BOP and helps countries pay for deficits in the current account.in the current account.

But it has costs: ‘debt servicing’ But it has costs: ‘debt servicing’ (payment of principal + interest).(payment of principal + interest).

Consequences of high indebtednessConsequences of high indebtedness1.1. Debt trap. If X revenues not enough for Debt trap. If X revenues not enough for

debt servicingdebt servicing→→ need to borrow more need to borrow more →→ larger debt service payments larger debt service payments →→ debt debt becomes unsustainable.becomes unsustainable.

2.2. BOP problems due to the high levels of BOP problems due to the high levels of debt.debt.

3.3. Lower private investment if fears that Lower private investment if fears that a government may be unable to service a government may be unable to service debts. Mainly short term investments.debts. Mainly short term investments.

4.4. Lower public investment. Less Lower public investment. Less resources for poverty alleviation and resources for poverty alleviation and social services.social services.

5.5. Diversion of X revenues away from Diversion of X revenues away from needed imports and towards debt needed imports and towards debt servicing.servicing.

6.6. 3, 4 and 5 3, 4 and 5 → → Lower economic Lower economic growthgrowth

Consequences of policies intended to Consequences of policies intended to address high indebtedness in LDCsaddress high indebtedness in LDCs. In . In the 80s, IMF and World Bank the 80s, IMF and World Bank intervened to avoid that some LDCs intervened to avoid that some LDCs defaulted on their loans. As a defaulted on their loans. As a consequence:consequence:

• Debt burden has decreasedDebt burden has decreased• But in some cases at the expense of But in some cases at the expense of

economic growth.economic growth.

1.1. Policies imposed by IMFPolicies imposed by IMF Mainly loan restructuring (ie, granting Mainly loan restructuring (ie, granting

of new loans with longer time period of new loans with longer time period and lower and lower i i ). Requirement: meet ). Requirement: meet policy requirements imposed by the policy requirements imposed by the IMF.IMF.

These were tight fiscal and monetary These were tight fiscal and monetary policies intended to:policies intended to:o ↓ ↓Gov spending (by reducing provision Gov spending (by reducing provision

of merit goods) and of merit goods) and ↑↑gov revenues (by gov revenues (by increasing prices of services provided increasing prices of services provided by public firms, imposition of fees for by public firms, imposition of fees for education and health services)education and health services)

o ↑↑Interest ratesInterest rateso ↓ ↓ AD and ↓ Demand for MAD and ↓ Demand for M

This led to lower econ growth, This led to lower econ growth, ↑↑ UE and UE and ↑↑ poverty. poverty.

2.2. Low success of HIPC initiative. In the Low success of HIPC initiative. In the 90s, WB and IMF begun this initiative 90s, WB and IMF begun this initiative to provide debt relief to a number of to provide debt relief to a number of highly indebted poor countries by highly indebted poor countries by cancelling a portion of their debts. cancelling a portion of their debts. Conditions:Conditions:

Follow certain WB, IMF policies such as Follow certain WB, IMF policies such as ↓ ↓ G and liberalize markets.G and liberalize markets.

Pursue a poverty reduction strategy.Pursue a poverty reduction strategy.

CriticismsCriticisms: Insufficient level of debt : Insufficient level of debt reduction, takes effect too slowly, reduction, takes effect too slowly, severity of some measures, many highly severity of some measures, many highly indebted countries were not included in indebted countries were not included in the initiative.the initiative.

3.3. Increased foreign control of domestic Increased foreign control of domestic assets due to debt-for-equity swaps.assets due to debt-for-equity swaps.

Debt for equity swaps: a highly indebted Debt for equity swaps: a highly indebted country exchanges a portion of its debt country exchanges a portion of its debt for equity, which is taken up by foreign for equity, which is taken up by foreign corporations. The foreign corporation corporations. The foreign corporation takes responsibility for a portion of a takes responsibility for a portion of a government’s debt and in exchange the government’s debt and in exchange the government gives it ownership of some government gives it ownership of some of its assets. Much of Latin American of its assets. Much of Latin American privatization occurred this way.privatization occurred this way.

ProblemProblem: assests are frequently acquired : assests are frequently acquired at a large discount, so control of assets at a large discount, so control of assets is lost at a price far lower than the is lost at a price far lower than the market price.market price.

Capital flightCapital flight Definition: Large scale transfer of Definition: Large scale transfer of

privately owned financial capital to privately owned financial capital to another country.another country.

It results from high uncertainty and It results from high uncertainty and risk of holding domestic assets due to:risk of holding domestic assets due to:• Risk of confiscationRisk of confiscation• Sudden Sudden ↑↑ taxation taxation• Political instabilityPolitical instability• Anything leading to loss of value of the Anything leading to loss of value of the

domestic currency.domestic currency.

Problems:Problems:1.1. It involves a loss of financial capital that It involves a loss of financial capital that

could have been invested domestically.could have been invested domestically.2.2. Sale of domestic currency Sale of domestic currency →→ downward downward

pressure on its value, forcing gov to pressure on its value, forcing gov to devalue or allowing depreciation.devalue or allowing depreciation.

3.3. Worsens external debt problem, as it Worsens external debt problem, as it involves use of scarce foreign exchange involves use of scarce foreign exchange →→ ↑↑ need for external debt borrowing. need for external debt borrowing.

In Mexico in 94-95, political instability In Mexico in 94-95, political instability and lack of confidence in the economy and lack of confidence in the economy led to massive sales of pesos, a drop led to massive sales of pesos, a drop in foreign reserves, massive capital in foreign reserves, massive capital flight and devaluation of the peso.flight and devaluation of the peso.

Non-convertible Non-convertible currenciescurrencies Fully convertible currency: can be freely Fully convertible currency: can be freely

exchanged for other foreign currencies.exchanged for other foreign currencies. Fully non-convertible currency: cannot Fully non-convertible currency: cannot

be exchanged for other currencies be exchanged for other currencies because of government restrictions.because of government restrictions.

Non-convertible currency: convertible Non-convertible currency: convertible only for specified foreign transactions. It only for specified foreign transactions. It may apply to current acount and may apply to current acount and financial account transactions.financial account transactions.

Many LDCs still maintain non-Many LDCs still maintain non-convertibility for their financial convertibility for their financial accounts.accounts.

1.1. Non-convertibility for current Non-convertibility for current account transactionsaccount transactions (mainly foreign (mainly foreign trade). Conversion of currencies is trade). Conversion of currencies is subject to gov restrictions. For subject to gov restrictions. For example , only for specific imports and example , only for specific imports and exports consistent with gov objectives.exports consistent with gov objectives.

Today most countries have convertible Today most countries have convertible currencies for CA transactions.currencies for CA transactions.

Benefits: based on the principle that Benefits: based on the principle that Int’al trade should be conducted in the Int’al trade should be conducted in the context of competitive mkts. context of competitive mkts.

2.2. Non-convertibility for financial Non-convertibility for financial account (FA) transactionsaccount (FA) transactions. Implies . Implies gov control over what flows are gov control over what flows are permissible. Exceptions for: debt service permissible. Exceptions for: debt service payments, funds to be used in inward payments, funds to be used in inward FDI, inward flows due to borrowing, FDI, inward flows due to borrowing, financial investment by foreigners.financial investment by foreigners.

BenefitsBenefits of non-convertibility for FA of non-convertibility for FA::a)a) Capital flight can be avoided, as financial Capital flight can be avoided, as financial

capital cannot leave the country if the capital cannot leave the country if the domestic currency cannot be converted into domestic currency cannot be converted into foreign currencies.foreign currencies.

b)b) Currency speculation is also avoided.Currency speculation is also avoided.

c)c) Ability to conduct monetary policy Ability to conduct monetary policy independently of exchange rate considerations. independently of exchange rate considerations. In case of a recession, for example, the interest In case of a recession, for example, the interest rate can be lowered without risk of a rate can be lowered without risk of a depreciation.depreciation.

ConditionsConditions to be met before full convertibility. to be met before full convertibility.1)1) Stable political systemStable political system2)2) Sound fiscal and monetary policies that Sound fiscal and monetary policies that

encourage confidence in domestic assets and encourage confidence in domestic assets and currency.currency.

3)3) Sound macro policies that work to avoid wide Sound macro policies that work to avoid wide exchange rate fluctuations and large BOP exchange rate fluctuations and large BOP deficits.deficits.

4)4) Strong financial institutions that operate under Strong financial institutions that operate under gov regulation to avoid excessive risks.gov regulation to avoid excessive risks.

5)5) Mkt orientation, with well-functioning price Mkt orientation, with well-functioning price system that facilitates more efficient allocation system that facilitates more efficient allocation of resources and financial capital.of resources and financial capital.

BenefitsBenefits of full convertibility for FA of full convertibility for FA::1.1. Access to foreign capital markets Access to foreign capital markets

(ability to diversify financial (ability to diversify financial investments).investments).

2.2. Access to more varied and cheaper Access to more varied and cheaper sources of finance.sources of finance.

3.3. Encourages FDI.Encourages FDI.4.4. Permits inflows of financial capital, Permits inflows of financial capital,

as foreigners know they can sell as foreigners know they can sell their assets if they wish.their assets if they wish.

5.5. ↑↑ competition among financial competition among financial institutions institutions → → ↑ ↑ efficiency + ↓ costs.efficiency + ↓ costs.

6.6. Prevents black market for foreign Prevents black market for foreign exchangeexchange

7.7. 1 to 6 contribute to greater 1 to 6 contribute to greater economic growth.economic growth.

8.8. Facilitates efficient global Facilitates efficient global allocation of savings.allocation of savings.

Currency convertibility and financial crisesCurrency convertibility and financial crises. . Several East Asian countries experienced a severe Several East Asian countries experienced a severe

financial and economic crisis in the late 90s. These financial and economic crisis in the late 90s. These economies had extended convertibility of their economies had extended convertibility of their currencies to the FA (under pressure from the IMF). currencies to the FA (under pressure from the IMF).

In 1997, recession + declining confidence in the In 1997, recession + declining confidence in the economy triggered attacks on their currencies, economy triggered attacks on their currencies, resulting in massive capital flight and downward resulting in massive capital flight and downward pressures on the value of their currencies.pressures on the value of their currencies.

IMF stepped in with loans and imposed tight monetary IMF stepped in with loans and imposed tight monetary policy in order to curtail capital flight and help policy in order to curtail capital flight and help support the currencies. However, confidence was support the currencies. However, confidence was low and downward pressure on curr continued. High low and downward pressure on curr continued. High ii created negative growth, higher UE and poverty. created negative growth, higher UE and poverty.

According to Stiglitz, FA liberalization ‘...was the According to Stiglitz, FA liberalization ‘...was the single most important factor leading to the crisis’.single most important factor leading to the crisis’.