StudySpace: Economics in Development, 6th Edition

Worked Example: Anatomy of a Debt Crisis

Indonesia and Nigeria are large tropical countries blessed with oil wealth. Both
are members of OPEC. Both were torn by civil war in the 1960s. Until 1980 both
had similar levels of per capita income. Yet by 1989 Indonesia’s GDP per capita
was nearly double Nigeria’s, in terms of constant-dollar PPP measures. (See line 2
of Table 15–1.) During the 1980s per capita GDP fell by 4.5 percent per year in
Nigeria while it rose by 4.0 percent per year in Indonesia (from line 2). Between
1980 and 1989 Nigeria’s foreign debt grew from 9 to 119 percent of GDP, compared
to an increase from 28 to 59 percent in Indonesia. Nigeria has a severe debt
problem and had to arrange to reschedule its payments. Indonesia avoided this.
What explains Nigeria’s poor performance?

External factors bear part of the blame for Nigeria’s problems. The country’s
terms of trade (that is, the price of exports relative to the price of imports) more
than halved between 1980 and 1989 (see line 8), due to the dramatic fall in oil
prices in 1986. Indonesia suffered less of a decline in terms of trade, but only
because its exports were less concentrated on oil (see line 9). Both economies
faced the same world recession in the early 1980s, and Indonesia suffered a larger
rise in the interest rate on its external debt (line 7). So one cannot very well explain
the differences in performance by external factors.

Internal factors provide the best explanation. Nigeria’s macroeconomic policies
were inappropriate in many ways, quite in contrast to Indonesia’s. Throughout
the 1980s Nigeria maintained an overvalued exchange rate that penalized export
performance (line 18). Government policy also inhibited any diversification of
exports (line 9); this left the country vulnerable to the collapse of oil prices.
Nigeria’s policies failed to achieve much development in manufacturing (line
10) and prevented agricultural growth from even keeping pace with population
growth (lines 19 and 16), unlike the situation in Indonesia.

Nigeria ran astonishingly large government deficits throughout the period, in
contrast to Indonesia’s more manageable deficits of just over 2 percent of GDP
(line 11). Nigeria and Indonesia entered the 1980s with comparable investment
and savings rates, but Nigeria’s domestic performance got worse while Indonesia’s
got better. Moreover, investment efficiency in Nigeria was so poor that GDP
actually fell, despite much capital formation; in Indonesia the excellent ICOR
value for the 1970s was not sustained into the 1980s, but the ICOR did not
become particularly high. In part this was due to Nigeria’s shallow financial
policies (evident from line 12), which reduced the effectiveness of the financial
system in mobilizing savings and channeling them to productive investments.
In short, Nigeria borrowed heavily, but failed to grow because of inappropriate
macroeconomic policies. The country ended the 1980s with $33 billion in
foreign debt and little to show for it. Indonesia had a larger debt in absolute
terms, $53 billion, but the resources were used to support a decade of robust
economic growth, despite tumultuous world market conditions. Exercise 1
examines some of these themes in more detail.

Click here for Table 15-1

Exercises
1. In this exercise, we will explore the ways in which Nigeria differed from
Indonesia in the 1980s. The goal is to clarify why Nigeria faced a debt
problem and declining GDP, while Indonesia did not.

a. Consider first the extent of the debt burden.

(i) Explain how Indonesia’s accumulation of foreign debt differed
from that of Nigeria during the 1980s.

(ii) Between 1980 and 1989 the ratio of debt to GNP exactly doubled
in Indonesia (line 3) but the debt-service ratio (line 6) more than
doubled. What explains this discrepancy? (Hint: Recall that the
debt-service ratio equals principal plus interest payments divided
by exports.)

(iii) Harder. Between 1980 and 1989 the ratio of debt to GDP rose
more than tenfold in Nigeria, but the debt-service ratio rose just
fivefold. How can you explain this discrepancy?

(iv) Which country had a more onerous debt burden at the beginning of the decade? Explain.

b. The performance difference between the two countries is most
prominent in the growth of GDP per capita.

(i) Between 1980 and 1989 Nigeria’s GDP per capita (line 2) declined
by a total of percent while Indonesia’s rose by a total of
percent.

(ii) The growth of GDP per capita in Nigeria was percent per
year; the corresponding figure for Indonesia was percent
per year. [Hint: Value for year t = (value for year 0)(1 + g)t.]

c. Some, although not all, of Nigeria’s difficulties may be explained by
adverse external factors.

(i) Why did Nigeria’s terms of trade fall more sharply than those of
Indonesia? (Hint: World oil prices collapsed in 1986.)

(ii) Indonesia paid an average interest rate of just 2.6 percent on its
foreign debt in 1980. This was well below the market interest rate.
What is the explanation for this? And why did the interest rate paid
by Indonesia rise so much during the decade?

(iii) Interest rates in the world financial markets were substantially lower in 1989 than in 1980, yet the average interest rate on Nigeria’s debt rose over this period. How can one explain this disparity?

(iv) There was a major world recession in 1982. What trace of this, if any, can be discerned from the information presented in Table 15–1?

d. Internal causes go far toward explaining Nigeria’s poor performance.

(i) Compare the experience of Nigeria and Indonesia in terms of
mobilizing domestic savings; cite at least two pieces of evidence
from Table 15–1.

(ii) Which country did a better job of promoting nonfuel exports during
the 1980s? Explain.

(iii) On the basis of agricultural performance statistics, which country
would you expect to have reduced its need for food imports during
the 1980s? Which would have increased its need for food imports?
Explain.

(iv) Nigeria’s investment was less efficient than Indonesia’s. What evidence of this do you see in Table 15–1? How might this be related to financial market policies? To government budget policies? Explain.

(v) Can any of the difference in per capita income growth be explained
by population growth rates? Explain.

(vi) Between 1970 and 1989 Nigeria’s pubic foreign debt rose by $31
billion; Indonesia’s debt rose more, by $38 billion. Yet by 1989
Indonesia had lower debt-to-GDP and debt-to-export ratios than did
Nigeria. Why?

e. You now have enough information to evaluate the two countries’ debt
strategies.

(i) Considering the facts shown in Table 15–1, do you think that
Indonesia would have been wiser to avoid foreign borrowing
altogether? Explain your position.

(ii) Considering the facts shown in Table 15–1, do you think that
Nigeria would have been wiser to avoid foreign borrowing
altogether? Explain your position.

(iii) What are the main adjustments that would have been required for
either country to have avoided foreign borrowing altogether?

2. This exercise gives you practice working with the equations on debt
dynamics. To avoid errors and confusion, all the data given in percentages
should be converted to decimal units before being plugged into the
equations. As an example, use 0.12 instead of 12 percent even if the data
set is expressed in the latter format.

a. The basic equation showing how the amount of foreign debt changes
over time is dD/dt = iD + M – E. That is, the change in foreign debt
equals the amount of interest payments on existing debt (iD) plus the
financing needed to cover the trade deficit (M – E). We may divide both sides of this equation by D and reorganize the terms to obtain an
expression for the proportionate growth rate of the foreign debt, Gd,
as follows:

The growth rate of foreign debt equals the interest rate plus the size of
the trade deficit (relative to total exports) divided by the debt-to-export ratio. Given values for the right-side variables, we may calculate the proportionate change in the foreign debt consistent with the foreign exchange constraint.

(i) Table 15–2 presents pertinent data for four highly indebted countries at the end of the 1980s. Complete the blanks in the right-hand column.

Click here for Table 15-2

Jamaica: %

Madagascar: %

Zambia: %

 

(ii) To cover its debt-service payments plus its foreign exchange gap,
India would have to permit its foreign debt to rise by almost 21 percent per year (in nominal dollar terms). If GDP were growing by 7 percent per year (also in nominal terms, converted to dollars),
what would happen to the ratio of debt to GDP?

(iii) This situation cannot be sustained for long without accumulating an
unbearable debt burden. With reference to equation 15–1, what
kinds of adjustments were required for India to reduce Gd to more a
manageable level?

b. Equation 15–3 in the text shows that debt dynamics can also be stated in terms of the savings-investment gap: dD/dt = iD + I – Sd = iD + vY – sY = iD + (v – s)Y. This says that the change in foreign debt equals the amount of interest payments on existing debt (iD) plus the excess of investment over domestic savings, which must be financed by a net inflow of foreign savings (that is, an increase in liabilities to foreigners). Here again, we may divide both sides of this equation by D and then reorganize the terms to obtain an expression for the proportionate growth rate of the foreign debt:

In words, foreign debt grows at a rate equal to the interest rate plus the size of the savings-investment gap (relative to GDP) divided by the
debt-to-GDP ratio. Given the values for all the right-side variables, we
may calculate the proportionate change in the foreign debt consistent
with the savings-investment gap.

(i) Complete the blanks in Table 15–3,which presents pertinent data
for the same four countries in 1989. You will need to use some data
from the previous table.

Click here for Table 15-3

Jamaica: %

Madagascar: %

Zambia: %

(ii) With reference to equation 15–2, what kinds of adjustments would
be required for India to reduce G_dto more manageable levels?

c. The textbook also shows that the equation for debt equations can be solved to obtain the long-run debt ratio implied by the prevailing dynamics. Using the foreign exchange gap form of the relationship, the long-run debt ratio is

where g_e is the growth rate of exports. This is the steady-state solution to equation 15–1; it gives the long-run debt-to-export ratio that would be sustained given the values of (M-E)/E, i, and g_e.

(i) This formula can be turned around to answer the question, What
export growth rate is needed to prevent the D/E from rising? For
this purpose, you plug in the prevailing value of D/E and solve for
ge. Using the data from Table 15–2, the answer to this question is

g_e= 20.8 percent for India.
g_e= for Jamaica.
g_e= for Madagascar.
g_e= for Zambia.

(ii) Are these values of ge plausible as sustainable characteristics in the long run? (Keep in mind that exports are measured here in nominal dollars.)

d. The same analysis can be cast in terms of the savings-investment gap. In this case, the long-run debt ratio is

 

where v is the share of investment in GDP, s is the share of domestic
savings, and g_y is the growth rate of GDP. This is the steady-state solution to equation 15 –2; it gives the long-run debt-to-income ratio that would be sustained, given the values of (v – s), i, and g_y.

(i) This formula can be turned around to answer the question, What
GDP growth rate is needed to prevent D/Y from rising? For this
purpose, you plug in the prevailing value of D/Y and solve for g_y. Using the data from Table 15–3, the answer to this question is

g_y= 18.9 percent for India.
g_y= for Jamaica.
g_y= for Madagascar.
g_y= for Zambia.

(ii) Are these values of g_y plausible as sustainable characteristics in the long run? (Keep in mind that exports are measured here in nominal
dollars.)

e. What do you conclude about the need for an adjustment program in
these countries?

3. In this exercise, we explore the financial crisis (currency and/or banking
crises) in emerging markets. As the discussion in Chapter 15 of the textbook
notes, emerging markets undergoing full liberalization of their capital markets
tend to be prone to financial crises. Although the process is not well understood,
there are two major contending explanations. What may be called the
fundamentals view attributes the financial crises primarily to excessively
foreign credit-driven investment, large budget deficits, and uncompetitive
firms or banks. The expectations view, on the other hand, argues that
excessively large and short-term foreign credits make even otherwise sound
economies vulnerable to speculative attacks or self-fulfilling creditor panics.
This is all the more likely in situations where the loans are advanced to
banks willing to engage in risky investments and in countries with pegged
exchange rates.

Table 15–4 provides additional data to what is contained in Table 15–9
in the textbook for a number of emerging markets. The macroeconomic
data focus on financial systems, exchange rate regimes, foreign debt, and
government finances prior to or soon after the crises.

Click here for Table 15-4

a. List the countries with the following characteristics:

(i) Countries whose inflation rates exceed 20 percent.

(ii) Countries whose budget deficits exceed 3 percent of GDP.

(iii) Countries whose CA/GDP exceeds 5 percent.

(iv) Countries whose currency does not float freely.

(v) Countries whose loan-LIBOR interest-rate spreads are in double
digits.

(vi) Countries whose share of short-term debt in total debt exceeds 20
percent.

(vii) Countries whose ICRG risk level for portfolio investment falls
below 70 percent.

(viii) Countries whose ratio of bank liquid reserves to bank assets are in double digits.

(ix) Countries whose stock market capitalization falls below 50 percent
of GDP.

b. The fundamentals view emphasizes structural and policy distortions
which are captured mainly by the first five characteristics:

(i) Which countries show up in at least three of the listings in part a,
(i)–(v)?

(ii) Which of these countries experienced a financial crisis in the
1990s?

c. The expectations view of financial crises suggests that panics resulting from imperfect information can lead to a financial collapse even when the economic fundamentals are sound. Combining the data in Table 15–9 (from the textbook) and Table 15–4:

(i) Which countries show up in at least three of the listings in part a,
(vi)–(ix)?

(ii) Which of these countries experienced a financial crisis in the
1990s?

d. Which of the countries that did not appear in your answers for part b, (ii) and part c, (ii) nonetheless experienced financial crises in the
1990s?

e. Only a handful of the emerging economies continue to maintain
pegged exchange rates or imposed restrictions on short-term capital
flows following the 1997 Asian crisis. Name those countries.

f. Looking at your answers for parts b–e, what can you say about a
possible reconciliation of the two views as suggested in the following
remark regarding the 1997–1998 East Asian crisis:

Fixed exchange rate regimes, capital inflows . . . led to real appreciation, an investment boom in wrong sectors, an asset price bubble and large current account deficits that led to the accumulation of a large stock of short-term foreign liabilities . . . The exchange rate crisis that followed made things only worse as the currency depreciation increased the real burden of the foreign-currency denominated debt. Weak and not very credible governments that were not committed to structural reform exacerbated the policy uncertainty and the financial panic that followed.

 

 

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