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Collapse of ISI: Class Notes 4

Terms in this set (4)

LAC DEBT CRISIS DURING ISI
ISI Economic growth was greatly financed
via international savings.
1980: total external debt = $220 billion,
1989: total external debt = $414 billion

External Debt (ED): portion of a country's debt borrowed from foreign lenders (commercial
banks, governments, international financial institutions), including loans + interest. Usually, ED
gets paid back in the currency the loan was made.
High: 1987: 60% of GNI

INTERNAL REASONS BEHIND DEBT CRISIS
1. During ISI, LAC was in good standing and
subject of credit.
2. LAC needed to finance
SOEs
Long term projects
Projects w/late or not returns

INTERNAL REASONS BEHIND DEBT CRISIS
Type of Loans used to finance ISI:
1. International commercial banks
2. In dollars or hard currency
3. Floating interest rates
4. Repayments required at the short run
Debt Trap

INTERNAL REASONS BEHIND DEBT CRISIS
Combination of
Low/no returns of
investment
Long-term
projects
Short-term
obligations
+Corruption exacerbated the debt crisis.
inability to service the debt

EXTERNAL FACTORS OF LA DEBT CRISIS
International factors motivating the increasing borrowing trend:
1. 1974 increasing oil price (supply shock)
generated over abundance of money supply
which the OPEC deposited international
commercial banks Excess of money supply
Petrodollars
2. International com banks needed to paid interest
on the OPEC's deposits

EXTERNAL FACTORS OF LA DEBT CRISIS
International factors motivating the increasing borrowing trend:
Large
Money
Supply
means
Low
interest
rates

External meets internal factors:
Cheap $ (International Banks eager to give away loans)
LAC - ISI over confidence (LAC needed loans to finance industrialization.)

INTERNATIONAL INTEREST RATE
The U.S. Real
Prime Rates
between 1974-
1977 were
negative.
Borrowing was
very attractive
Capital flight occurs when a nation converts
their national assets into foreign currency and
takes it outside his/her home country (deposit or
investment)
exit of national assets

REVIEW: ISI MONETARY POLICY
LAC countries overvalued ER to artificially allow
purchasing foreign currency with fewer local
currency.
• Import technology and intermediate
goods cheaper.
• To contain internal inflation.

What corrects overvalued Exchange Rates?
Devaluation ER

DEVALUATION AND CAPITAL FLIGHT
Ex. In Honduras, a person owns 1000 Lempiras
when the ER is
L1 to $1, 1K Lempiras purchase $1K.
After a 20% devaluation, to purchase same $1K a
person in Honduras need 1.2K Lempiras

DEVALUATION & CAPITAL FLIGHT
What would you do if you expects an ER devaluation?
sell local currency and buy foreign currency and
move foreign currency out of the country
capital flight

Devaluation vicious cycle: local inflation -> devaluate ER -> higher local inflation

MONETARY POLICY TO DEFEND ER
To preserve or defend an overvalued currency,
central banks engaged in financial market
operations:
sell foreign currency (i.e. $) at the expense of
country's own reserves and buy local currency
The drawback of this monetary policy: everybody
knows that reserves are not unlimited.

MONETARY POLICY TO DEFEND ER
LOW reserves of hard currency at the central
bank sends a clear signal of weakness
damage confidence in the economy
people would suspect a
devaluation
promote capital flight

CAPITAL FLIGHT EXACERBATED DEBT CRISES
• Overvaluation and low reserves send red flag
local currency is likely be devaluated Loss
of confidence: nobody wants to hold
domestic assets that may loose their value.
• Corruption: Some international loans given to
alleviate low reserves: get deposit in personal
accounts outside the countries.

CAPITAL FLIGHT WAS SEVERE IN LAC
1980-82 capital
flight as % of total
external debt:
77% Argentina
73% Mexico
132% Venezuela

CONSEQUENCES OF CAPITAL FLIGHT
In an attempt to retain capital in local banks,
domestic interest rates increased
• Domestic credit gets more expensive
depressing local investment

CONSEQUENCES OF CAPITAL FLIGHT
Massive outflow of foreign currency from LAC to
developed countries:
• Lower imports of intermediate
inputs the industry need it, which
• Contracts production of
manufacture goods

CONSEQUENCES OF CAPITAL FLIGHT
Shrinks the taxable base
contracting sources of public
revenue & weakens the
government.

CONSEQUENCES OF CAPITAL FLIGHT
•Gov shortage of tax revenue + no
additional foreign loan forced
gov to print money to cover its deficit
↑Money Supply without increasing
production.
Contracts production and
econ growth

CONSEQUENCES OF CAPITAL FLIGHT
• Higher local money supply
sparks demand for foreign
currency instead of local currency
excess of local currency
supply & stagnant production:
D> S creates an inflationary
process.
Exacerbates the crises

LAC MAY NOT BE ABLE TO PAY ITS DEBT