G
CHAPTER 15
Developing Countries and
International Finance II: The
Global Capital Flow Cycle
lobal investors became nervous in the summer of 2017 in the face of
discussion about tightening monetary policy in the United States and
European Union. At the center of investor concern was the fear that tighter
policy in the U.S. would spark a substantial outflow of capital from
emerging markets. Large and sustained capital outflows would force
governments in emerging market economies to raise interest rates, erode
their accumulated foreign exchange reserves, and possibly spark currency
crises and broader balance-of-payments crises. Such fears arose in the
summer of 2017 because memories of the way markets reacted to the U.S.
decision to tighten monetary policy in 2013 and 2014 remained fresh. In
that period, stock markets in emerging economies fell and interest rates
rose sharply as investors shifted back into dollar-denominated assets in
response to rising interest rates in the U.S. The episode angered many
emerging market policymakers, who accused the Federal Reserve of
showing little concern for how its policy affected emerging market
economies.
This episode constitutes the most recent manifestation of a broader
dynamic in the global financial system, called the global capital flow
cycle, that has come into sharp relief since 1990. The global capital flow
cycle is characterized by two central components. One component is a
two-phase cycle in the distribution of cross-border capital flows. In one
phase, financial capital flows into emerging market economies in large
volumes, where it strengthens currencies and inflates asset prices. In the
second phase, investors sell their emerging market assets in favor of
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dollar-denominated assets, thereby depressing asset prices, raising interest
rates, and creating the risk of banking and currency crises. The second
component is the role of American monetary policy in shifting the cycle
from one phase to the other. When interest rates fall in the U.S., capital
flows to emerging markets in search of higher returns. When interest rates
in the U.S. rise, capital flows out of emerging markets and back into
dollar-denominated assets. American policy thus generates a capital flow
cycle that increases financial volatility in the emerging market economies.
Although this global capital flow cycle was an important factor in the
evolution of the Latin American debt crisis, the cycle has become more
pronounced since 1990. Since 1990, the capital flow cycle has gone
through two full rotations. The first rotation began in the early 1990s with
large and sustained capital inflows to a small number of Asian economies,
Argentina, Brazil, Mexico, Russia, and Turkey. This phase of the cycle
ended with a series of crises that began in the late 1990s and widespread
calls for reform of the global crisis management regime. The second
revolution began in the wake of the 2008 U.S.-centered financial crisis as
loose monetary policy in the U.S. encouraged investors to search for
higher returns in emerging market economies. The shift to a more
restrictive monetary policy in the U.S. since 2014 has created substantial
volatility for emerging markets, but has not yet produced a major banking
or currency crisis. The challenges governments face in managing their
economies in the face of the volatilities generated by this capital flow
cycle has caused the International Monetary Fund to become more
forgiving of capital controls.
We examine this global capital flow cycle in this chapter. We look first
at the series of crises that struck during the 1990s, focusing deeply on the
largest of them: the 1997 Asian crisis. We then examine how that crisis
subsequently prompted considerable discussion about reforming the
international financial system in order to alter how crises are managed and
to try to reduce the frequency of such crises in the future. We then look at
the most recent revolution of the cycle, which began in the wake of the
U.S. financial crisis of 2008. The chapter concludes by drawing some
more general lessons.
THE ASIAN FINANCIAL CRISIS
The first revolution of the global capital flow cycle occurred between 1990
and 1999. Developing countries attracted little new private capital during
the 1980s. It was not until the end of the decade and after reform had taken
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root that private capital began flowing again. Private capital flows resumed
in a changed environment, however. On the one hand, policies toward
private capital flows were radically different. Although most governments
had restricted capital flows in connection with import substitution, many
dismantled these controls in connection with policy reforms implemented
during the 1980s and early 1990s. Consequently, it became much easier
for private individuals to move capital into and out of emerging markets.
On the other hand, financial liberalization in advanced industrialized
countries had increased the importance of securities—stocks and bonds—
as sources of financing. The growing importance of nonbank capital flows
was reinforced by the lingering effect of the Latin American debt crisis:
few banks were willing to lend to countries that had so recently defaulted.
These changes combined to alter the composition, as well as the scale,
of private capital flows to the developing world. The importance of
commercial bank lending diminished, whereas that of bond and equity
flows increased. Most private capital flows to Latin America during the
1990s, for example, financed government and corporate bonds and
purchased stocks in newly liberalized stock markets. By the mid-1990s,
private capital flows to the entire developing world had risen to about 3
percent of these countries’ gross domestic product (GDP) (see Figure
15.1). Asia was the largest recipient of capital inflows prior to 1997,
accounting for almost 50 percent of total flows to all developing countries
in the first half of the decade. Latin America was the second-largest
recipient, obtaining between one-quarter and one-third of all flows to
developing countries (IMF 2000).
The resumption of private capital flows generated one crisis after
another. The growing importance of bond and equity flows, often referred
to as hot money because it can be withdrawn at the first hint of trouble,
increased the volatility of private capital flows to these “emerging market”
countries. Although developing countries have struggled with such
volatility throughout the last 100 years, volatility increased during the
1990s compared with earlier periods (IMF 2001, 163; World Bank 2001a).
Historical evidence suggests that more volatile capital flows have been
associated with lower economic growth rates over the long run (World
Bank 2001a, 73). In addition, the record of the 1990s indicates that
increased volatility of private capital flows is associated with more
frequent financial crises that substantially reduce economic growth for a
year or two.
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FIGURE 15.1
Gross Private Capital Inflows to Emerging Market Economies, 2009–2015
Note: Excludes foreign direct investment flows.
Sources: Clark et al., 2016; World Bank, Global Development Finance 2004 CD-Rom, Table
1.1 (Washington, DC: World Bank Publications, 2004); World Bank, Global Development
Finance 2005 CD-Rom, Table 1.1 (Washington, DC: World Bank Publications, 2005) and
World Bank, Global Development Finance 2008 CD-Rom, Table 1.1 (Washington, DC:
World Bank Publications, 2008).
Such financial crises became all too common during the 1990s. Mexico
experienced the first one in late 1994. Four Asian countries—Indonesia,
Malaysia, South Korea, and Thailand—had severe crises in the summer
and fall of 1997. Brazil and Russia both experienced crises in 1998.
Turkey and Argentina were struck by crises in 2000 and 2001. Each crisis
was distinctive in some way, and yet all shared important similarities (see
Table 15.1). First, each country struck by a crisis maintained some form of
fixed exchange rate. In most instances, governments maintained a crawling
peg or the slightly less restrictive crawling band. Second, each country
developed a heavy reliance on short-term foreign capital.
The combination proved perilous. Heavy dependence on short-term
capital required the continual rollover of foreign liabilities. The ability to
roll over these liabilities depended critically on the government’s ability to
maintain foreign investors’ confidence in its commitment to the fixed
exchange rate. In each crisis, foreign investors lost confidence in that
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commitment. The trigger for crisis varied. Sometimes it was a political
shock, as in Mexico; sometimes it was an economic shock, as in Russia
and Argentina; sometimes it was contagion from crises in other regions. In
all instances, however, the evaporation of foreign investors’ confidence in
the government’s commitment to the fixed exchange rate triggered
massive capital outflows that forced governments to devalue and (with the
lone exception of Brazil) pushed the country into deep economic crisis. In
many instances, the economic crisis toppled governments as well.
The Asian financial crisis of 1997 provides the clearest illustration of
the challenges these countries faced. The Asian crisis originated in
political and economic dynamics in four countries: Thailand, Indonesia,
South Korea, and Malaysia. During the late 1980s and early 1990s, the
government in each country liberalized their financial markets to make it
easier for domestic banks and firms to borrow on international financial
markets. In Thailand, for example, the government created the Bangkok
International Banking Facilities in 1992 in an attempt to make Thailand an
Asian banking center. The government hoped that Thai banks would
borrow on international markets and then lend the funds obtained to
borrowers across Asia. Financial liberalization thus enabled Asian banks to
intermediate the flow of funds from international lenders to domestic
borrowers. The incentive for such intermediation was powerful. Interest
rates in international markets were considerably lower than interest rates
inside Asian economies. Asian banks could thus borrow money at a
relatively low rate of interest, such as 9 percent, from foreign commercial
banks and then lend it to domestic borrowers at a much higher rate of
interest, such as 12 percent.
TABLE 15.1
A Chronology of Crises, 1994–2002
Mexico (December 1994–January 1995)
Exchange Rate: Crawling band pegged to the dollar.
Financing Problem: The Mexican government began issuing shortterm
debt linked to the U.S. dollar in April 1994 (Cetes, analogous
to U.S. Treasury bonds) to reduce its interest rate. The value of the
Cetes issued soon exceeded the central bank’s foreign exchange
reserves.
Trigger: Unrest in Chiapas province generated a speculative attack in
early December.
IMF Support: Mexico secured credits for $48.8 billion, including
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$17.8 billion from the IMF and $20 billion from the U.S.
government.
Fallout: The government devalued the peso by 15 percent on
December 20 and then floated the peso on December 22. The peso
depreciated from 3.64 per dollar to more than 7 per dollar. Mexico
suffered a depression and severe banking problems that prompted
government rescues.
Contagion: Speculative attacks spread throughout Latin America and
Asia.
East Asia (July 1997–January 1998)
See details in this chapter.
Russia (August 1998)
Exchange Rate: Crawling band pegged to the dollar.
Financing Problem: The Russian government was paying very high
interest rates on large short-term debt.
Trigger: Falling prices for oil (the country’s major export) and weak
growth generated speculative attacks. The government widened the
ruble’s band by 35 percent in August and then floated the ruble in
early September. The ruble depreciated from 6.2 per dollar to more
than 20 per dollar.
IMF Support: Russia secured IMF credits of $11.2 billion in July
1998.
Fallout: The government defaulted on its ruble-denominated debt and
Soviet-era foreign debt and imposed a moratorium on privatesector
payments of foreign debt. The economy fell into recession.
Many Russian banks became insolvent.
Contagion: Speculative attacks spread to Latin America, hitting
Brazil especially hard. The U.S. hedge fund Long Term Capital
Management was pushed to the brink of bankruptcy and was
rescued in an effort coordinated by the Federal Reserve Bank of
New York.
Brazil (January 1999)
Exchange Rate: Crawling band pegged to the U.S. dollar.
Financing Problem: Growing government debt and a sizable currentaccount
deficit generated large short-term external debt.
Trigger: The Russian crisis and the subsequent collapse of Long
Term Capital Management generated speculative attacks between
August and October ofgenerated speculative attacks between
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August and October of 1998. Attacks resumed in early 1999 when
a state government defaulted on payments to the federal
government. The real was devalued by 9 percent on January 13,
1999, and then floated on January 18. The currency depreciated
from 1.21 per dollar to 2.18.
IMF Support: Brazil secured an IMF credit of $18 billion on
December 2, 1998.
Fallout: Mild; growth strengthened in 1999 and 2000. The financial
system suffered little.
Contagion: Brazil’s devaluation contributed to recessions in
Argentina and Uruguay and generated speculative attacks that
forced Ecuador to float in February 1999.
Turkey (February 2001)
Exchange Rate: Crawling peg against the dollar and the German
mark.
Financing Problem: Large government short-term debt and a large
current-account deficit generated heavy dependence on short-term
foreign capital.
Trigger: Concern about a criminal investigation into ten governmentrun
banks in late November 2000 generated a speculative attack.
Eight banks became insolvent and were taken over by the
government. Investors lost confidence in February 2001 when
conflict between the president and prime minister weakened the
coalition government. The government floated the lira on February
22, and it depreciated from 668,000 per dollar to 1.6 million per
dollar by October 2001.
IMF Support: Turkey secured an IMF credit of $10.4 billion on
December 21.
Fallout: The Turkish economy contracted by 7.5 percent in 2001.
Contagion: None.
Argentina (2001)
Exchange Rate: Fixed to the U.S. dollar.
Financing Problem: Large government short-term debt.
Trigger: Speculative attacks against this peg emerged in 2000 and
continued sporadically into 2001. The government introduced
some exchange-rate flexibility in mid-2001, generating new
speculative attacks. The government floated the peso in January
2002 and defaulted on its foreign debt.
IMF Support: Argentina secured a total of $40 billion in credits from
the IMF and the advanced industrialized countries.
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Fallout: Argentina’s economy collapsed into deep depression.
Contagion: None.
Sources: Compiled from information in Eichengreen 2001; Joint Economic
Committee 2003; and material on the IMF website (www.IMF.org).
Such intermediation was risky. Asian banks contracted short-term loans
denominated in dollars and other foreign currencies from foreign banks
and then offered these funds as long-term loans denominated in the
domestic currency to local borrowers. Asian banks thus confronted two
kinds of risk. First, they faced exchange-rate risk, which arose from the
possibility that the government would devalue the local currency. Were
this to happen, the domestic currency cost of servicing the dollardenominated
loans would rise substantially. At the extreme, the domestic
currency cost would rise above the payments that Asian banks were
receiving from the businesses to which they had lent money. Asian banks
were also exposed to the risk that foreign lenders would stop rolling over
their short-term loans. Because Asian banks had borrowed on a short-term
basis and then made long-term loans, they needed foreign lenders to renew
the loans every 6 or 12 months. If foreign commercial banks became
unwilling to rollover loans, Asian banks would be forced to repay all of
their short-term debt at once. Yet, because these funds were tied up in the
long-term loans that the Asian banks had made to local borrowers, the
Asian banks would be unable to raise the funds needed to repay their debts
to foreign banks.
The ability of Asian banks to intermediate safely between international
and domestic financial markets was compromised by flaws in Asian
countries’ financial regulations. The central weakness was a problem
called moral hazard, which arises when banks believe that the
government will bail them out if they suffer large losses on the loans they
have made. If banks believe that the government will cover their losses,
they have little incentive to carefully evaluate the risks associated with the
loans they make. If borrowers repay, banks earn money. If borrowers
default, the government—and society’s taxpayers—pick up the tab. In
such an environment, banks have an incentive to make riskier loans than
they would make in the absence of a promise of a government bailout.
This incentive arises because banks charge higher interest rates to highrisk
borrowers. As a result, higher-risk loans, when they are repaid, yield
higher returns than low-risk loans. A government guarantee thus creates a
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one-way bet for banks: lend heavily to risky borrowers and they will profit
greatly if the loans are repaid, yet they will suffer little if they are not,
because the government will bail them out. The danger is that the practice
of lending heavily to high-risk borrowers makes a systemic financial crisis
more likely. Banks will lend too much to risky borrowers, and too many of
these high-risk borrowers will default. Banks will therefore lose money,
forcing the government to step in and bail them out. The government
guarantee thus makes a financial crisis more likely.
Moral hazard was particularly acute in many Asian countries. Financial
institutions had close ties to governments, sometimes through personal
relationships and sometimes through direct government ownership. In
Indonesia, for example, seven state-owned banks controlled half of the
assets in the banking system (Blustein 2001, 94), and relatives and close
friends of Indonesian President Suharto controlled other financial
institutions. In the past, such relationships had led governments to rescue
banks and other financial institutions in distress. In Thailand, for example,
the government rescued the Bangkok Bank of Commerce in 1996 at the
cost of $7 billion (Haggard 2000, 25). In Indonesia, two large corporate
groups rescued Bank Duta (which held deposits from President Suharto’s
political foundations) after it had lost $500 million in foreign exchange
markets. The corporate rescuers were in turn rewarded by the Suharto
regime (Haggard 2000, 26). Given this recent history, foreign and
domestic financial institutions participating in the Asian market had reason
to believe that Asian governments would not allow domestic financial
institutions to fail. This belief in turn led international investors to lend
more to Asian banks, and Asian banks to lend more to Asian businesses,
than either would have been willing to lend had Asian governments not
rescued banks in the past.
In principle, governments can design financial regulations to prevent the
risky lending practices to which moral hazard so often gives rise. Banking
regulation can limit the activities that financial firms engage in and thereby
confine the overall risk in lending portfolios. In the Asian-crisis countries,
however, such financial regulation was underdeveloped, and where it did
exist, it was not effectively enforced. In Indonesia, for example, any
regulator “who attempted to enforce prudential rules … was removed from
his position” (Haggard 2000, 33). Nor was this kind of treatment restricted
to civil servants: the managing director of the central bank was fired in
1992, and the minister of finance was fired in 1996 (Haggard 2000, 33).
As Haggard notes, the more general problem lay in the “influence that
business interests exercised over legislation, regulation, and the legal
436
process” (Haggard 2000, 38). In other words, the same network of
business–government relations that created the moral hazard problem in
the first place also weakened the incentives that governments had to
develop and enforce effective prudential regulations. As a consequence,
there were few regulatory checks on the lending practices of Asian
financial institutions.
This regulatory framework enabled Asian banks to accumulate financial
positions that could not easily withstand exogenous shocks. Asian
economies were hit by shocks in late 1996 and early 1997. First, Asian
countries’ exchange rates began to appreciate against the Japanese yen in
the mid-1990s. Most Asian governments pegged their currencies to the
dollar. As the dollar appreciated against the yen in the mid-1990s, Asian
currencies appreciated too. Exchange-rate appreciation made it difficult for
domestic firms to export to Japan, one of their major export markets,
which in turn created debt-service problems for export-oriented firms.
Second, real-estate prices began to fall in late 1996, creating debt-service
problems for real-estate developers. In March, the Thai government
purchased $4 billion of debt that property developers owed but were
unable to pay to domestic banks. By 1997, therefore, many of the Asian
banks’ largest domestic borrowers were struggling to service their debts.
As a consequence, the number of non-performing loans—loans on which
interest payments had not been made for 6 months or more—held by Asian
banks began to grow. Because domestic borrowers could not repay
domestic banks, the domestic banks could not easily repay foreign banks.
Domestic debt-service difficulties thus began to generate international
debt-service difficulties.
Weaknesses in Asian financial systems became a source of general
concern in the spring of 1997. The trigger was the discovery that one of
Thailand’s largest financial institutions, Finance One, was insolvent. The
discovery caused foreign banks to look much more closely at banks
throughout Asia. Close inspection indicated that Finance One’s situation
was not unique; banks across Asia were facing similar problems as a result
of appreciating currencies and popping real estate bubbles. Deteriorating
conditions in Asian financial systems and shifting international market
sentiment combined to produce a panicked withdrawal of funds from
Asian markets in the summer of 1997. Foreign banks that had loaned
heavily to Asian banks refused to roll over existing loans and demanded
repayment of whatever loans they could. Funds also started flowing out of
Asian stock markets.
The panic began in Thailand in May 1997, where it quickly consumed
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the Thai government’s foreign exchange reserves and forced the
government to float the baht. The panicked withdrawal of funds from Asia
over the next 6 months struck practically every country in the region. After
their experience with Thailand, financial markets shifted their attention to
the Philippines, forcing the government to abandon its fixed exchange rate
after only 10 days. Attention shifted to Indonesia and Malaysia in July and
August, and governments in both countries responded to massive capital
outflows by abandoning their fixed exchange rates and allowing their
currencies to float. From there, speculation targeted Taiwan, forcing a
devaluation of the Taiwanese dollar, and Hong Kong, where capital flight
caused the Hong Kong stock market to lose about one-quarter of its value
in only 4 days. The crisis moved to South Korea in November, forcing the
government to float the won by the middle of the month. A total of $60
billion was pulled from the region in the second half of 1997, roughly twothirds
of all the capital that had flowed into the region the year before. An
additional $55 billion was pulled out in 1998 (IMF 1999, 92).
As the crisis struck, Asian governments turned to the IMF for financial
assistance. The Philippines was the first to do so, gaining a $1.1 billion
credit on July 14. The Thai government turned to the IMF 2 weeks later
and was provided $16 billion from the IMF and other Asian countries.
Indonesia held out longer, turning to the IMF only in October and
receiving a $23 billion package. South Korea received the most support
from the international community, acquiring a $57 billion package in early
December. In all, the four hardest-hit countries—South Korea, Indonesia,
Thailand, and Malaysia—received $117.7 billion.
As in earlier crises, IMF assistance was conditional upon economic
reform. The reforms incorporated into IMF conditionality agreements in
the Asian crisis targeted three broad areas: macroeconomic stabilization,
reform of the financial sector, and structural reform. Macroeconomic
stabilization programs were necessary, the IMF argued, to restore market
confidence in the crisis countries and to stem capital outflow.
Governments tightened monetary policy to stem the depreciation of their
currencies. They tightened fiscal policies to generate the financial
resources needed to rebuild the financial sector. Finally, the IMF required
Asian governments to implement structural reforms, including trade
liberalization, elimination of domestic monopolies and other
uncompetitive practices and regulations, and privatization of state-owned
enterprises. In Thailand, structural reforms targeted the civil service and
state-owned enterprises. In Indonesia, the IMF pressed the government to
deregulate agriculture and reduce the monopoly position of the national
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agriculture marketing board. The IMF pressed the Indonesian government
to privatize 13 state-owned enterprises and to suspend the development of
auto and commercial aircraft industries.
TABLE 15.2
Economic Growth and Current-Account Balances in
Asia
1995 1996 1997 1998
Economic Growth (annual percent change)
Thailand 8.8 5.5 −0.4 −5.0
Indonesia 8.2 8.0 4.6 −13.7
South Korea 8.9 7.1 5.5 −5.8
Current-Account Balance (percent of gross domestic product)
Thailand −7.8 −7.9 −2.0 6.9
Indonesia −3.2 −3.3 −1.8 1.6
South Korea −1.9 −4.7 −1.9 7.3
Source: International Monetary Fund (IMF), IMF Annual Report (Washington, DC:
IMF, 1999).
The crisis had severe economic and political repercussions. The
financial crisis and macroeconomic stabilization precipitated deep
recessions throughout Asia. Indonesia experienced the biggest downturn,
with economic output contracting by more than 13 percent in 1998. In
most countries, the economic crisis hit the poor the hardest, and as a
consequence, poverty rates rose sharply. In Indonesia, the number of
people living below the poverty line grew from 11 percent of the
population to 19.9 percent in 1998. In South Korea, the poverty rate rose
from 8.6 percent to 19.2 percent in 1998. Deteriorating economic
conditions sparked protest and political instability. In Indonesia, economic
crisis sparked large-scale opposition to the Suharto government’s
corruption, nepotism, and cronyism. As the crisis deepened, regime
opponents demanded fundamental political reform and a reduction of basic
commodity prices, particularly of energy and rice. Protests and opposition
peaked in May 1998. Four students were killed by the military during an
anti-Suharto demonstration at Triskati University, sparking even larger
protests during the days that followed. By late May, Suharto had stepped
439
down from office.
The economic crisis sparked political change in Thailand as well.
Thailand had begun constitutional reform in the early 1990s but had stalled
under competing visions of how the new political institutions should be
structured. Acceptance of the new constitution by the major societal
groups was “propelled forward” by the economic crisis. As Haggard
(2000, 94) notes, it is “highly doubtful that [this political reform] would
have occurred in the way that it did in the absence of crisis circumstances.”
In addition, the government that had presided over the economy in the
years leading up to the crisis was unable to maintain a majority coalition. It
was replaced in November 1997 by a new government based on a 5-party
coalition dominated by the Democrat Party, the oldest political party in
Thailand. The Democrat Party was “free of the more egregious patronage,
pork-barrel spending, and corruption of its opponents” (Haggard 2000,
94). In Indonesia and Thailand, therefore, economic crisis provoked a
reaction against the corruption of previous governments, mobilized
societal support for far-reaching constitutional reform, and brought to
power groups committed to economic and political reform.
A Closer Look
Cancelling the Debt for the World’s Poorest Nations
By the late 1990s, the world’s poorest countries, most of which are
located in sub-Saharan Africa, owed about $200 billion to foreign
creditors. Most of this debt was owed to official lenders—to the World
Bank and the IMF or to governments in the advanced industrialized
world. Payments to service this debt in 1999 (before the latest debtrelief
initiative had taken effect) amounted to slightly more than $3
billion, a sum equal to 21 percent of government revenue and 15
percent of export earnings. The indebted countries are very poor.
Roughly half of their combined population of 615 million people were
living on less than $1 per day, and for at least ten of these countries,
per capita income in 1999 had fallen below the level of 1960.
Such heavy debt burdens depressed economic growth in subSaharan
Africa. Facing large debt payments, governments were forced
to devote a sizable share of their available domestic resources to debt
service. Large debt burdens also make it impossible to attract new
foreign capital. Private lenders are unwilling to lend to countries that
are unable to service their existing debt, so private capital flows are
not an option. Official lenders also are increasingly reluctant to offer
440
new loans. As the scale of the debt problem grew, the World Bank and
the IMF, as well as many of the bilateral donors, became increasingly
focused on restructuring existing debt rather than on providing new
loans, and any new loans that were forthcoming were typically offered
primarily to facilitate debt service. As a consequence, large debts
essentially forced countries to forgo access to fresh foreign capital.
The creditor governments managed the African debt crisis by using
essentially the same negotiation and rescheduling process that they had
employed to manage the Latin American debt crisis. African
governments negotiated stabilization and structural adjustment
packages with the IMF and the World Bank, which then provided
additional financial support, and existing debt was rescheduled. By the
late 1980s, official creditors were concluding that the heavily indebted
countries would never be able to repay their debts and that the level of
debt service was having seriously deleterious consequences on those
countries’ economic performance. As this recognition took hold,
creditor governments began to offer debt-reduction packages to the
most heavily indebted poor countries.
The results from debt-reduction programs provided during the 1990s
were disappointing. In spite of reducing foreign debt by around $60
billion, debt-service burdens actually increased for the poorest
countries (IMF 2000; Easterly 2002, 125–126). Consequently, and
partly in response to pressure from a coalition of nongovernmental
organizations and religious groups, the World Bank and the IMF
launched the Heavily Indebted Poor Countries (HIPC) debt
initiative in September 1996. The most novel aspect of the HIPC
initiative was that, for the first time, creditors would reduce the debt
owed to multilateral lenders. All previous debt-relief measures had
focused on debt owed to other governments, or bilateral debt. With
HIPC, officials finally recognized that they would have to reduce the
debt owed to the World Bank, the IMF, and the regional development
banks.
Eligibility for the HIPC initiative was limited to the world’s poorest
countries. Moreover, in its initial design, the program was not intended
to eliminate all foreign debt in these countries, but to reduce this debt
to sustainable levels (Van Trotsenberg and MacArthur 1999). The IMF
and the World Bank estimated that the typical country that completed
the program would see its debt reduced by two-thirds and its debtservice
ratio cut in half. Like other IMF and World Bank programs, the
HIPC initiative incorporated conditionality. The initiative was
441
structured around a two-stage process. In stage one, governments
worked with domestic groups, the IMF, and the World Bank to
develop Poverty Reduction Strategy Papers (PRSP). The PRSP
described the macroeconomic, structural, and social policies the
government would adopt in order to foster growth and reduce poverty.
The idea was for governments to establish track records of
implementing the strategy presented in the PRSP. At the end of the
stage, countries would reach the “decision point,” at which time the
IMF and the World Bank conducted a debt-sustainability analysis to
determine the country’s eligibility for debt forgiveness. In stage two,
the government continued to adhere to the PRSP targets until the IFIs
were satisfied that it was committed to the program. Once the IMF and
the World Bank concluded that the government had satisfactorily
implemented its program, the country reached the “completion point”
and gained the full amount of debt relief committed at the decision
point.
The HIPC initiative was an important step in the management of the
debt burden. However, critics charged that HIPC would not fully
resolve the debt crisis, and that a full resolution required 100-percent
forgiveness (see, for example, Roodman 2001; Birdsall and
Williamson 2002). By the fall of 2004 some governments in the
advanced industrialized countries were reaching the same conclusion
(Blustein 2004b). The Group of Eight (G-8) initially discussed 100percent
forgiveness for the HIPC countries during the IMF–World
Bank meetings in October 2004; by early June of 2005, the G-8
finance ministers had officially proposed that the World Bank, the
IMF, and the African Development Fund (ADF) forgive all of their
claims on the countries in the HIPC process. This first official call for
100-percent cancellation was reaffirmed by the G-8 heads of state 1
month later at the G-8 Summit in Gleneagles, Scotland. Governments
announced the final details of this initiative, christened the
Multilateral Debt Relief Initiative (MDRI), at the IMF World Bank
meetings in March 2006. The cost of cancellation, estimated at the
time at $50 billion, was financed through contributions to the
multilateral lenders by the advanced industrialized countries.
By 2017, the HIPC initiative and the MDRI had eliminated
practically all of the accumulated foreign debt burden for the 36
heavily indebted developing countries that had reached the completion
point (World Bank 2017a). In all, the programs relieved these 36
countries of $101.4 billion of debt, shrinking their combined foreign
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debt burden to only $5 billion at the end of 2015. Consequently, the
debt-to-GDP ratios had fallen from 114 percent in 1999 to 22 percent
in 2015. Encouragingly, current indicators suggest that now that they
are no longer burdened by large foreign debts, governments in these
societies are dedicating at least a portion of the resources previously
directed to debt service to critical social programs such as health and
education.
BRETTON WOODS II
Perhaps the most profound consequence of the Asian crisis concerned not
just East Asia but the entire international financial system. Arguably the
roots of the 2008–2009 global financial crisis lie in East Asian
governments’ responses to the 1997 crisis. East Asian governments drew
one overarching lesson from the crisis and crisis management: don’t allow
the economy to become vulnerable to shifts in market sentiment or subject
to IMF intervention. As we have seen, crises induced by capital flows were
politically destabilizing; IMF conditions reflected American interests and,
as a consequence, carried deeply intrusive and often inappropriate policy
demands. Thus, the central lesson governments drew from the crisis was,
“never again.”
East Asian governments relied on two mechanisms to reduce the
likelihood that they faced future crises that pushed them to the IMF. The
first line of defense was self-insurance through the accumulation of large
stocks of foreign exchange reserves. Starting from less than zero in the
crisis countries, and not substantially above zero in other countries, East
Asian governments as a group accumulated more than $4 trillion in foreign
exchange reserves between 1998 and the end of 2009. This amount
constituted slightly more than half of global reserve holdings (U.S.
Department of the Treasury, 2010). China accumulated the largest stock of
foreign exchange reserves by far, holding about $2.4 trillion by the end of
2009. Japan, with the second largest stock, held just less than $1 trillion.
Asian governments accumulated foreign exchange reserves by running
persistent and large current account surpluses. Up until the 1997 crisis,
most economies ran current account deficits in most years. These deficits
were financed by the capital inflows that eventually triggered the crisis.
These deficits disappear in 1998, however, and from 1998 until the crisis
hit in 2009, East Asian economies ran large current account surpluses.
Indeed, as we saw in Chapter 11, East Asian economies emerged as
important creditor countries after 2000.
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East Asian economies have been able to run persistent current account
surpluses in part because they have pegged their currencies to the dollar at
competitive (many analysts argue undervalued) exchange rates. The
competitive exchange rates encourage exports and discourage imports. Of
equal importance, however, has been the dominant tendency to engage in
sterilized intervention to maintain these exchange-rate pegs. Under
sterilized intervention, a government with a current account surplus will
exchange local currency for foreign currency at the fixed rate and then
subsequently offset the impact of these purchases on the domestic money
supply. Consequently, government foreign exchange reserve holdings
increase, but the money supply does not. The currency thus remains
competitively valued. In East Asian countries, the government then used
the foreign exchange reserves (largely dollars) to purchase U.S.
government securities and government-backed securities.
Policy Analysis and Debate
Does China’s Creditor Status Confer Political Power?
Question
Does the Chinese government’s status as a large lender to the United
States government confer creditor power that China can exploit to alter
American policy?
Overview
During the last decade, the Chinese government has emerged as the
single largest foreign lender to the United States government. China’s
current account surpluses have generated an increase in the Chinese
government’s official dollar holdings. Rather than hold these reserves
in the form of dollars, which pay no interest rates, China has used
them to purchase relatively safe financial instruments that do pay
interest. U.S. government debt is the safest instrument available.
Hence, China’s current account surpluses have transformed China into
a major foreign funder of U.S. government debt. At the end of May
2010, China owned $868 billion worth of U.S. government securities
(United States Department of the Treasury, 2010). This constitutes
about 6.5 percent of total U.S. debt, but about 22 percent of total
foreign-owned U.S. debt. Hence, a substantial share of U.S.
government debt is controlled by a single foreign government that is
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not closely allied with the United States. Moreover, the ability for the
United States to run deficits rests, in part, on the continued willingness
of the Chinese government to acquire and hold U.S. government debt.
China’s emergence as an important creditor to the U.S. government
has raised questions about financial power. Some argue that its
creditor status confers upon China substantial power. China’s creditor
position might make it difficult to defend American interests in Asia.
As President Obama remarked during the campaign, “It’s pretty hard
to have a tough negotiation when the Chinese are our bankers” (cited
in Drezner 2009, 15). China might also gain leverage over U.S. policy
at home. A threat to dump U.S. debt or to refuse to purchase more
could sharply increase the cost of funding the debt. The desire to avoid
these costs could encourage the U.S. to change policy in line with
China’s interests. Other analysts argue that creditor status does not
confer much power. They emphasize the interdependent nature of the
relationship. China buys U.S. debt so that the United States can buy
Chinese goods. Moreover, because China holds so much U.S. debt, a
massive sell-off would be quite painful.
Policy Options
China’s status as a major creditor to the U.S. government confers
power that China can exploit and that must be a source of concern
for the U.S. government.
China’s status as a major creditor results from economic
interdependence and thus does not generate exploitable power.
Policy Analysis
What factors determine whether creditor status confers political
power?
How does China’s trade relationship with the United States
influence its orientation toward the acquisition of additional U.S.
debt?
What if anything could China do to exploit its status without
reducing the value of its assets?
Take A Position
Which option do you prefer? Justify your choice.
What criticisms of your position should you anticipate? How
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would you defend your recommendation against these criticisms?
Resources
Online: Visit the U.S. Department of the Treasury’s “Treasury
International Capital System” to update the data on foreign
ownership of U.S. government debt.
www.treasury.gov/tic/fpis.shtml
In Print: Daniel Drezner. 2009.“Bad Debts: Assessing China’s
Financial Influence in Great Power Politics.” International Security,
34(2): 7–45, and Brad Setser, Sovereign Wealth and Sovereign
Power: The Strategic Consequences of American Indebtedness
(New York: Council on Foreign Relations, 2008).
The system that results from these arrangements has come to be called
“Bretton Woods II” (Dooley, Folkerts-Landau and Garber 2004). East
Asian governments peg to the dollar because the United States is their
most important trade partner. East Asian economies run persistent trade
surpluses with the United States (and with the world as a whole). East
Asian governments finance exports in excess of imports by using the
dollars they earn from their export surplus to purchase and hold U.S.
government debt instruments. These arrangements are a modern-day
Bretton Woods for two reasons. First, the U.S. trade deficit drives growth
in East Asia, just as the U.S. current-account imbalance drove early
postwar growth in Europe. Moreover, the system is stable as long as East
Asian countries are willing to accumulate claims on the U.S. government,
just as the original Bretton Woods system was stable as long as European
governments were willing to accumulate claims on U.S. gold.
As a second line of defense, East Asian governments created a regional
framework for financial cooperation (see Henning 2002 and Chey 2009).
Called the Chiang Mai Initiative, this regional body provided framework
within which governments could pool their foreign exchange reserves to
assist each other in the event of market turbulence. The idea of an Asian
mechanism first emerged in the fall of 1997. Wary of American and IMF
objectives in the conditionality agreements, Japan proposed an Asian
Monetary Fund that would effectively supplant the IMF in the region. The
proposal drew strong opposition from the United States, who viewed it as
a challenge to American interests in the region, and indifference from
many East Asian governments, who were a bit wary of Japanese ambitions
in the region. The proposal also failed to attract support from China.
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Consequently, the Japanese stepped back from the initiative.
The push for regional financial cooperation re-emerged in late fall 1997.
Still fuming at their treatment by the IMF, ASEAN governments invited
China, Japan, and South Korea to their summit to explore financial
cooperation. By 1998, the ASEAN + 3 finance ministers had begun
discussion about creating a system of bilateral swap arrangements to
provide liquidity to governments facing balance-of-payments problems. In
May of 2000, while meeting in Chiang Mai, Thailand, the governments
announced that they had reached agreement on the basic framework.
Through the CMI, governments pledge to make available a total of $120
billion. China and Japan are the two largest contributors, each contributing
$38 billion. South Korea contributes approximately $19 billion, and the
balance of contributions comes from governments in the ten smaller
ASEAN countries. Each participant in the Initiative would be entitled to
swap its currency for U.S. dollars in the amount equal to its contribution
times its “purchasing multiplier.”
Bretton Woods II arguably played a key role in the development of the
global financial crisis of 2008–2009. The global savings glut, the favored
term of many U.S. policymakers, is another name for the huge stock of
foreign exchange reserves East Asian governments accumulated. East
Asian societies saved as much as 50 percent of their income after 1997,
and used an important share of these funds to purchase U.S. government
securities. The plentiful demand for U.S. government debt instruments
drove down interest rates, and this cheap credit arguably sparked the asset
bubbles that popped in 2007 and 2008. Somewhat ironically, therefore,
policies that East Asian governments adopted to reduce the likelihood that
they would experience another crisis at home contributed to the
development of an even larger crisis abroad.
CURRENCY WARS, TAPER TANTRUMS, AND
THE GLOBAL CAPITAL FLOW CYCLE
For the developing world as a whole, though, the early 2000s were a
period of financial stability. Because investors focused their attention on
the American property market capital flows to emerging markets remained
relatively low. Moreover, governments in developing countries took
advantage of the period to stabilize their economies and accumulate
reserves. By 2008, the financial situation in the developing world had
improved greatly. Outstanding IMF credit had fallen to less than $10
billion, the lowest level in almost 30 years, an indication that developing
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countries had not only avoided new crises after 2000 but also that they had
repaid the loans they had acquired in the late 1990s.
This decade of financial stability in the emerging markets was brought
to a close by U.S. policy as the Federal Reserve sought to induce economic
recovery in the wake of the global financial crisis. The first political
manifestation of the emerging financial volatility came in the fall of 2010
when Brazilian Finance Minister Guido Mantega accused the United
States—and the Federal Reserve specifically—of sparking an international
currency war. Mantega’s allegation came in midst of a series of rather
complex reactions of capital markets and currency markets to America’s
monetary policy as the Federal Reserve transitioned from restoring
financial stability to fostering post-crisis economic recovery. As an attempt
to promote economic activity, the Federal Reserve implemented a second
round of quantitative easing, known as QE2, in November 2010. Under
QE2, the Fed announced that it would purchase $600 billion worth of U.S.
Treasury securities by the middle of 2011. Such purchases would keep
U.S. interest rates low. Low interest rates would encourage private
investment that would in turn boost economic output and employment.
The Fed extended its policy of quantitative easing in 2012 (which became
QE3), as it committed to purchasing $40 billion worth of Treasury
securities every month.
The Fed’s expansionary monetary policy had unintended consequences
(spillovers) for the global economy in general and for emerging market
economies in particular. Most fundamentally, low interest rates in the U.S.
economy encouraged investors to search for higher returns in other
countries. Investors thus sold dollar-denominated assets and purchased
financial assets in Asian and Latin American economies that had been
relatively unaffected by the 2008 financial crisis. As a result, financial
capital poured out of dollar-denominated assets and into emerging market
assets, causing the dollar to depreciate rather sharply between May 2010
and May 2011. Policymakers in some countries, including in Japan and
China, appeared to be intervening in currency markets in an attempt to
devalue their currencies against the sinking dollar in order to retain export
competitiveness. As a consequence, other emerging market economies
with fixed exchange rates were losing export competitiveness and facing
strong pressure from domestic industry to devalue. The Brazilian Real was
especially hard hit as foreign capital flowed into the Brazilian economy.
By late 2010, Goldman Sachs proclaimed the Brazilian currency the
world’s most overvalued currency (Reuters 2010). It was in this context
that Mantega accused the Federal Reserve of triggering an international
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currency war.
The large influx of foreign capital triggered by the Fed’s QE2 had
consequences for emerging market countries that stretched beyond
currency values. Easy access to credit triggered investment booms in many
emerging market countries, while overvalued currencies encouraged this
investment to flow into nontraded activities such as real estate and
construction. As a result, asset prices began to rise rapidly in emerging
market countries from 2011, generating fears of an emerging market
housing bubble. Governments in many emerging market economies
responded to these developments by introducing capital controls in an
attempt to divert the inflow. Moreover, and perhaps somewhat
surprisingly, this return to capital controls was supported by the
International Monetary Fund as it moved toward a new “Institutional
View” on capital flows that recognized the potential utility of capital
controls in the face of large and possibly destabilizing cross-border flows
(see IMF 2011). By late 2012, markets had stabilized.
Stability was short lived however, as the tempers of many emerging
market policymakers flared again as the Federal Reserve began to shift
away from quantitative easing in the middle of 2013. In May 2013, in the
context of his semi-annual testimony to Congress’ Joint Economic
Committee, Federal Reserve Board Chairman Ben Bernanke suggested
that the Fed might begin to reduce the amount of these purchases—Fed
purchases of Treasury Securities would taper off—sometime in the near
future. Such a shift in Fed policy would cause interest rates to rise in the
U.S. In early 2014, the Federal Reserve began to taper.
The shift in American monetary policy hit emerging market economies
very hard. Investors that had only months previously been too eager to
acquire assets in emerging market economies now rushed to liquidate their
assets as fast as they could. Equity markets slumped, governments’ foreign
exchange reserves eroded, and currencies depreciated. Moreover, the
suddenness of the shift in investor sentiment was dramatic—practically
overnight. The destabilizing consequences for emerging market economies
that resulted from the Federal Reserve’s policy shift generated substantial
and often very outspoken anger (which was rather patronizingly termed a
“taper tantrum”) among policymakers in emerging market countries.
Raghuram Rajan, who at the time was the Governor of the Reserve Bank
of India, was among the most vocal critics of American policy. He accused
the Fed of refusing to take into account the impact its policy shift had on
the rest of the world. In a speech delivered at the Brookings Institution in
Washington, DC, Rajan asked rhetorically, “If the policy hurts the rest of
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the world more than it helps the United States, should this policy be
pursued” (Caruso-Cabrera 2014). Rajan’s critical perspective was not
welcomed by the engineer of the Fed policies, Ben Bernanke, who was in
attendance (though no longer the Chairman of the Federal Reserve Board)
and challenged Rajan’s claim during the question and answer session that
followed Rajan’s speech.
Rajan’s concerns were hardly unique. Indeed, by early 2014 global
policymakers, investment banks, and media outlets were becoming
increasingly concerned about the financial health of five emerging maret
economies—India, Brazil, Turkey, South Africa, and Indonesia. Foreign
capital had driven an economic boom in each of these economies and as a
consequence continued growth had become highly exposed to changes in
market sentiment. Of particular concern was the possibility of a sudden
change in market sentiment that would trigger a large sell-off, a run on
central bank foreign exchange reserves, and a systemic banking crisis. In
this case, however, governments moved proactively in an attempt to stem
the sell-off. In January, the Turkish central bank responded to market
speculation against the Turkish lira by increasing interest rates by 4.25
percentage points—a massive one-time rise. South Africa’s central bank
pushed its main rate up the next day, though by a much smaller amount.
India had also pushed up its lending rate to reassure nervous investors. To
this point, however, the tapers have generated substantial volatility,
considerable uncertainty, but have not precipitated a major banking or
currency crisis.
This episode highlighted once again two enduring characteristics of the
global financial system. First, the system is characterized by a recurring
two-phase global cycle in which capital flows between the center of the
system in one phase and then to the emerging markets in the other phase.
Second, the transition between phases is triggered by changes in U.S.
monetary and fiscal policy. And though the specific details of this most
recent capital flow cycle are unique, in broad outline the same systemic
dynamic generated the Latin American debt crisis and the Asian crisis that
we explored earlier in this chapter. The most distinctive aspect of this most
recent manifestation of the capital flow cycle is that neither systemic
banking nor sovereign debt crises have materialized. Perhaps this indicates
that the lessons that governments in the emerging market economies drew
from the Asian crisis helped their financial systems withstand the most
recent period of volatility. Nevertheless, moving forward, we again
confront the realization that reducing the amplitude of the capital flow
cycle will require closer macroeconomic cooperation than we have
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observed during the last 30 years.
CONCLUSION
At the beginning of the twenty-first century, developing countries are
facing new challenges in managing their relationship with the international
financial system. On the one hand, international financial integration over
the last 20 years has greatly expanded developing countries’ opportunities
for attracting foreign capital. Yet, those countries seem incapable of
escaping from a repeating cycle of overborrowing, crisis, and adjustment
that lies at the center of their difficulties. As we have seen, this cycle
typically starts with changes in international capital markets. Petrodollars
increased the supply of foreign capital to many developing countries
during the 1970s, and the dynamics of international financial integration
increased the supply of foreign capital to Asian countries during the 1990s.
Developing countries have exploited the opportunities presented by
changes in international financial markets with great enthusiasm. By
reducing the constraints imposed by limited savings and limited foreign
exchange, foreign capital allows developing countries to invest more than
they could if they were forced to rely solely on domestic resources. The
problem, however, is that developing countries eventually accumulate
large foreign currency exposures that they cannot service and are pushed
to the brink of default. Impending default causes foreign lenders to refuse
additional loans to developing countries and to recall the loans they had
made previously. Now shut out of international capital markets,
developing countries experience severe economic crises and implement
stabilization and structural adjustment packages under the supervision of
the IMF and the World Bank. This cycle has repeated three times in the
last 40 years, once in Latin America during the 1970s and 1980s, once in
Asia during the 1990s, and most recently across a geographically diverse
set of emerging market economies.
These cycles are driven by the interaction between developments in the
international system and those within developing countries. The cycle is
driven in part by interests and institutions in the international system over
which developing-country governments have little control. The volume
and composition of capital flows from the advanced industrialized
countries and the developing world have been shaped in large part by
changes in international financial markets and changes in American
monetary policy. The build-up of debt in Latin America during the 1970s
was made possible by the growth of the Euromarkets and the large
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deposits in these markets made by OPEC members. The buildup of large
foreign liabilities by many Asian countries resulted in part from the more
general increase in international financial integration during the late 1980s.
The ability to service foreign debt is also influenced by international
developments. In the Latin American debt crisis, rising American interest
rates and falling economic growth in the advanced industrialized world
made it more difficult for Latin American governments to service their
foreign debt. In the Asian crisis, the dollar’s appreciation against the yen
made it more difficult for Asian borrowers to service their debt. Finally,
the advanced industrialized countries, the IMF, and the World Bank have
established the conditions under which developing countries experiencing
crises can regain access to foreign capital.
Interests and institutions within developing countries have also played
an important role. Domestic politics influence how much foreign debt is
accumulated and the uses to which it is put. In the 1970s, Latin American
governments made poor decisions about how to use the foreign debt they
were accumulating, thereby worsening their situation when the
international environment soured. In Asia, governments failed to regulate
the terms under which domestic banks intermediated between foreign and
domestic financial markets, thereby weakening domestic financial systems
and sparking an erosion of investor confidence in Asia. A country’s ability
to return to international capital markets following a crisis is contingent on
policy reform. Domestic politics often prevents governments from
speedily implementing such reforms. Thus, even though it might be
tempting to place the blame for the cycle solely on the international
financial system or solely on developing-country governments, a more
reasonable approach is to recognize that these cycles are driven by the
interaction between international and domestic developments.
KEY TERMS
Bretton Woods II
Capital Flow Cycle
Chiang Mai Initiative
Heavily Indebted Poor Countries (HIPC)
Hot Money
Moral Hazard
Multilateral Debt Relief Initiative
SUGGESTIONS FOR FURTHER READING
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On the Asian financial crisis, see Stephan Haggard, The Political Economy of the
Asian Financial Crisis (Washington, DC: Institute for International Economics,
2000).
For a broader examination of emerging market strategies in the global financial
system, see the contributions in Leslie Elliott Armijo and Saori N Katada, eds.,
The Financial Statecraft of Emerging Powers: Shield and Sword in Asia and
Latin America. (London: Palgrave Macmillan, 2014).
For the global financial cycle, see Obstfeld, Maurice, and Alan M. Taylor, 2017.
“International Monetary Relations: Taking Finance Seriously.” Journal of
Economic Perspectives 31(3): 3–28, Sarah Bauerle Danzman, W. Kindred
Winecoff, and Thomas Oatley, 2017. “All Crises Are Global: Capital Cycles in
an Imbalanced International Political Economy.” International Studies
Quarterly 61(4): 907–923, and Atish R. Ghosh, Jonathan D. Ostry, and
Mahvash S. Qureshi, Taming the Tide of Capital Flows: A Policy Guide
(Cambridge, MIT Press, 2017).
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