Chapter 21

International Lending and Financial Crises

Overview

International capital movements can bring major gains both to the lending or investing countries
and to the borrowing countries, through intertemporal trade and through portfolio diversification
for the lenders/investors. But international lending and borrowing sometimes is not well-behaved
—financial crises are recurrent. This chapter examines both the gains from well-behaved lending
and borrowing and what we know about international financial crises.

We begin with the economic analysis of international capital flows that focuses on the stock of
wealth of two countries and how that wealth can be lent or invested in the two countries. With no
international lending, the country that has much wealth relative to its domestic investment
opportunities will have a lower rate of return or interest rate. Freeing international capital flows
permits the low-rate country to lend to the high-rate country. As the world shifts to an
equilibrium with free capital movements, both countries gain. As usual, however, within each
country there are groups that gain and groups that lose from the international lending.

We can also use this analysis to show that either nation could gain by imposing a small tax on
the international capital flows, because it could shift the pre-tax foreign interest rate in its favor.
Either country could seek to impose a nationally optimal tax, but this works well only if the other
country does not impose a comparable tax.

International lending and borrowing often is well-behaved, but not always. The chapter next
examines financial crises in developing countries during 1982 to 2002. Following defaults in the
1930s, lending from industrialized countries to developing countries was low for four decades.
Such lending dramatically increased in the 1970s for four reasons. First, oil-exporting countries
deposited large amounts of petrodollars in banks following the increases in oil prices. Second,
the banks did not see good prospects for lending this money to borrowers for capital spending in
the industrialized countries. Third, developing countries resisted foreign direct investment from
multinationals based in the industrialized countries, so increased capital flows to the developing
countries took the form of bank loans to these countries. Fourth, herd behavior among banks
increased the total amount lent to developing countries.

Crisis struck in 1982, when first Mexico and then many other developing countries declared that
they could not repay. The crisis was brought on by rising interest rates in the United States,
which raised the cost of servicing the loans, and declining export earnings for the debtor
developing countries, as the industrialized countries endured a deep recession. This debt crisis
wore on through the 1980s. Beginning in 1989, the Brady Plan led to reductions in debt and
conversion to bonds. By 1994, the 1980s debt crisis was finally over.

Beginning in about 1990 lending to developing countries began to grow rapidly. Low U.S.
interest rates led lenders and investors to seek out better returns elsewhere, and many developing
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countries became more attractive as places to invest by shifting to more market-oriented policies.
In addition, individual investors and fund managers began to view developing countries as
emerging markets for financial investments.

Still, the 1990s were punctuated by a series of financial crises. In late 1994 a large current
account deficit, a weak banking system, and rapid growth in dollar-indexed Mexican government
debt (tesobonos) led to a large devaluation and depreciation of the Mexican peso and a financial
crisis as foreign investors refused to buy new tesobonos. Contagion (the “tequila effect”) spread
the crisis to other countries. A large rescue package offered mostly by the U.S. government and
the International Monetary Fund (IMF) contained the crisis and the contagion.

The Asian crisis of 1997 hit Thailand first and then spread to Indonesia and South Korea, as well
as Malaysia and the Philippines. The problems differed somewhat from one country to another,
but one cause of the crisis was weak government regulation of banks, so that the banks borrowed
large amounts of foreign currency, and then lent these funds to risky local borrowers. In addition,
the growth of exports generally was declining for these countries, leading to some weakness in
the current account.

Russia was not much affected directly by the Asian crisis, but it had a large fiscal deficit and the
need for large borrowing by the government. By mid-1998 foreign lenders reduced their
financing, and an IMF loan foundered when the Russian government failed to enact changes in
its fiscal policy. In the face of rising capital flight, the Russian crisis hit, as the Russian
government allowed the ruble to depreciate and defaulted on much of its debt. With no rescue
from the IMF, foreign lenders and investors suffered large losses. They reassessed the risk of
lending to developing countries, and flows of capital to developing countries declined for the
year.

Argentina pegged its peso to the U.S. dollar and succeeded in ending its hyperinflation in the
early 1990s. However, the peso experienced an increase in its real effective exchange rate value,
and an extended recession began in 1998. The fiscal deficit widened, and the IMF stopped
lending to it in late 2001. In early 2002 the government ended the pegged exchange rate and the
peso lost three-fourths of its value relative to the U.S. dollar. The banking system largely ceased
to function and the economy went into a severe recession. After a few months delay Argentina’s
crisis spread to neighboring countries, especially Uruguay.

Based on a survey of studies of financial crises in developing countries, the chapter discusses
five reasons why they occur or are as severe as they are. The explanations have a common theme
—once foreign lenders realize that there is a problem, each has an incentive to stop lending and
to try to get repaid as quickly as possible. If the borrower cannot immediately repay, a crisis
occurs.

The first explanation is overlending and overborrowing. This can occur when the government
borrows and guarantees private borrowing, and lenders view this as low risk. The box on “The
Special Case of Sovereign Debt” uses a benefit-cost analysis to show when a sovereign debtor
would default. The Asian crisis showed that overlending and overborrowing could occur with
private borrowers as well, especially if rising stock and land prices show high returns until the

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bubble bursts. The second explanation is exogenous shocks—for instance, a decline in export
prices or a rise in foreign (often U.S.) interest rates—that make it more difficult for the borrower
to service its debt. The third is exchange rate risk. This can be acute if private borrowers use
liabilities denominated in foreign currency to fund assets denominated in local currency, betting
that the exchange rate value of the local currency will not decline (too much). If it does,
borrowers attempt to hedge their risk exposure, putting further downward pressure on the
exchange-rate value of the local currency, and then they may be forced to default if the local
currency is depreciated or devalued more, before they can fully hedge their risk exposures. The
fourth explanation is a large increase in short-term debt to foreigners. The risk is that short-term
debt denominated in foreign currency cannot readily be rolled over or refinanced.

The first four explanations indicate why a financial crisis can hit a country. The fifth explanation
—contagion—indicates why a crisis in one country can spread to others. Contagion can be
herding behavior by investors, perhaps fed partly by incomplete information on other countries
that might have problems similar to those of the crisis country. Contagion can also be based on a
new recognition of real problems in other countries, with the crisis in the first country serving as
a “wake-up call.”

When a financial crisis hits a developing country, two major types of international efforts are
used to help resolve it. First, a rescue package, often led by an IMF lending facility, can be used
to compensate temporarily for the lack of private lending, to try to restore lender confidence, to
try to limit contagion, and to induce the government of the borrowing country to improve its
macroeconomic and other policies. While the Mexican rescue in 1994 was very successful in
helping Mexico weather the crisis, the rescue packages for the Asian crisis countries were only
moderately successful. A key question is whether the rescue packages increase moral hazard, so
that future financial crises become more likely because lenders lend more freely if they expect to
be rescued. The Mexican rescue probably increased moral hazard, with mixed effects from the
Asian rescues. The lack of a rescue for Russia reduced moral hazard as lenders lost substantial
amounts with no rescue package implemented. (The box “Short of Reserves? Call 1-800-IMF-
LOAN,” another in the series on Global Governance, describes the IMF’s lending activities and
its use of conditionality.)

Second, debt restructuring (rescheduling and reduction) is used to create a more manageable
stream of payments for debt service. Restructuring can be difficult because an individual lender
has an incentive to free ride, hoping that other creditors will restructure while demanding full
repayment as quickly as possible for its own loans. The Brady Plan overcame the free rider
problems to resolve the debt crisis of the 1980s. During the debt crises of the 1990s, it was
relatively easy to restructure debt owed to foreign banks. A new problem was the great difficulty
of restructuring bonds, because the legal terms of most bonds gave powers to small numbers of
bondholders to resist restructuring. The shift to bonds that include collective action clauses
should reduce this problem.

We now are paying more attention to finding ways to reduce the likelihood or frequency of
financial crises in developing countries. Some proposals for improved practices in borrowing
countries, including better macroeconomic policies, better disclosure of information and data,
avoiding government short-term borrowing denominated in foreign currencies, and better

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regulation of banks, enjoy widespread support. Other proposals are controversial, with experts
sometimes pointing in opposite directions. Developing countries should shift to relatively cleanly
floating exchange rates, or they should move to rigid currency fixes through currency boards.
The IMF should have access to greater amounts of resources so it can help countries fight off
unwarranted financial attacks, or the IMF should be abolished to reduce moral hazard. The text
looks more closely at two proposals for reform, the need for better bank regulation, and the
controversial proposal that developing countries should make greater use of capital controls to
limit capital inflows, and especially to limit short-term borrowing.

Financial crises also hit industrialized countries, and the chapter concludes with an examination
of the global financial and economic crisis. The crisis began in the United States, which had
experienced a credit boom and a bubble in house prices. As the house price bubble began to
deflate in 2006, an increasing number of mortgages went into default. In August 2007 problems
at BNP Paribas signaled the depth of losses on securities backed by these mortgages.
Furthermore, financial institutions became reluctant to lend to each other, because potential
lenders became worried that the borrowing institutions may hold dodgy assets that made it more
likely that they could not service their debts in the future. With the failure of Lehman Brothers in
September 2008, short-term financial markets and lending among financial institutions froze, and
the crisis entered a much worse phase. The U.S. Federal Reserve and other central banks
responded with efforts to inject liquidity and shore up financial institutions and markets. By late
2009 most financial markets were operating reasonably well. The chapter concludes with an
examination of how the causes of the global crisis are in several ways similar to the causes of
crises in developing countries.

The box “National Crises, Contagion, and Resolution,” in the new series on the euro crisis,
discusses how the euro crisis was three interlocking crises (sovereign debt, banking, and
macroeconomic) that fed on each other.

Tips

Many students have a keen interest in international lending and investing and financial crises.
This chapter can also readily be supplemented with readings from recent press articles on
developments (e.g., in Greece or in Italy) in the aftermath of the euro crisis.

The first section or two of this chapter on the gains from international capital flows and the
taxation of international capital flows can be assigned and covered in conjunction with the
material of Chapters 2-15 (especially the analysis of direct investment and migration in Chapter
15).

If this chapter is assigned before students read the second half of Chapter 20, the instructor may
want to assign the box “The International Monetary Fund” as required reading to provide an
introduction to the organization.

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Suggested answers to questions and problems
1. Disagree. Borrowing from foreign lenders provides a net gain to the borrowing country,
as long as the money is used wisely. For instance, as long as the money is used to
finance new capital investments whose returns are at least as large as the cost of
servicing the foreign debt, then the borrowing country gains well-being. This is the gain
of area (d + e + f ) in Figure 21.1.

2. Disagree. In a sense a national government cannot go bankrupt, because it can print its
own currency. But a national government can refuse to honor its obligations, even if it
might be able to pay. If the benefit from not paying exceeds the cost of not paying, the
government may rationally refuse to pay. And, a national government can run short of
foreign currency to pay obligations denominated in foreign currency, because it cannot
print foreign money.

3. The surge in bank lending to developing countries during 1974–1982 had these main
causes: (1) a rise in bank funds from the “petrodollar” deposits by newly wealthy oil-
exporting governments; (2) bank and investor concerns that investments in
industrialized countries would not be profitable because the oil shocks had created
uncertainty about the strength of these economies; (3) developing countries’ resistance
to foreign direct investment, which led these countries to prefer loans as the way to
borrow internationally; and (4) some amount of herding behavior by bank lenders,
which built on the momentum of factors (1) through (3) and led to overlending.

4. The debt crisis in 1982 was precipitated by (a) increased cost of servicing debt, because
of a rise in interest rates in the United States and other developed countries as tighter
monetary policies were used to fight inflation, (b) decreased export earnings in the debtor
countries, because of decreased demand and lower commodity prices as the tighter
monetary policies resulted in a world recession, and (c) an investor shift to curtailing new
lending and trying to get old loans repaid quickly, once it became clear that (a) and (b)
would lead to some defaults.

5. a. World product without international lending is the shaded area. We first need to calculate
the intercepts for the two MPK lines. The negative of the slope of MPKJapan is 1 percent per
600, so the intercept for Japan is 12 percent. The “negative” of the slope of MPKAmerica is
also 1 percent per 600, so the intercept for America is about 14.7 percent. Japan’s product
is the rectangle of income from lending its wealth at 2 percent (120) plus the triangle above
it (300), which is income for everyone else in Japan. America’s product is the rectangle of
income from lending its wealth at 8 percent (320) plus the triangle above it (about 134),
which is income to everyone else in America. Adding up these four components yields a
total world product of 874.

b. Free international lending adds area RST (54), so total world product rises to 928.

c. The 2 percent tax results in a loss of area TUV (6), so total world product falls to 922.

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6. With free international lending Japan lends 1,800 (= 6,000 − 4,200) to America, at point
T. If Japan and America each impose a 2 percent tax on international lending, the total
tax is 4 percent. The gap WZ restores equilibrium, and the amount lent internationally
declines to 600 (= 6,000 − 5,400). The interest rate in Japan (and the one received net of
taxes by Japan’s international lenders) is 3 percent and the interest rate in America (and
the one paid including taxes by America’s international borrowers) is 7 percent. (The
difference is the 4 percent of taxes.) Japan’s government collects international-lending
tax revenues equal to area r, but this is effectively paid by Japanese lenders who see their
earnings on the 600 of foreign lending that continues decline by this amount. The net
effect on Japan is a loss of area n because the taxes prevent some previously profitable
lending from occurring. America’s government collects tax revenues equal to area k, but
this is effectively paid by American borrowers who must pay a higher interest rate on
their foreign borrowing. The net effect on America is a loss of area j because of the
decline in international borrowing.

7. a. A large amount of short-term debt can cause a financial crisis because lenders can refuse to
roll over the debt or refinance it and instead demand immediate repayment. If the
borrowing country cannot meet its obligations to repay, default becomes more likely.

b. Lenders can become concerned that other countries in the region are also likely to be hit
with financial crises. This contagion can then become a self-fulfilling panic. If lenders refuse
to make new loans and sell off investments, the country may not be able to meet its
obligations to repay, so default becomes more likely. And the prices of the country’s stocks
and bonds can plummet as investors flee.

8. a. The increase in the interest rate rotates the line showing the debt service due, which is
also the benefit from not repaying, upward to (1 + i)D from (1 + i)D. The threshold
amount of debt beyond which the country’s government should default declines to Dlim
from Dlim. This change can lead to default, even if the country’s government would not
default before the change, if the actual amount of debt is between Dlim and Dlim.

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 b. The increase in the cost of defaulting causes an upward shift to C from C in the curve
showing the costs of not repaying. In this case the threshold increases to Dlim from Dlim.
This change cannot lead to default if the country would not default before the change.

9. a. If lenders had detailed, accurate, and timely information on the debt and official reserves
of a developing country, they should be able to make better lending and investing
decisions, to avoid overlending or too much short-term lending. Better information
should also reduce pure contagion, which is often based on vague concerns that other
developing countries might be like the initial crisis country. In addition, developing
countries that must report such detailed information are more likely to have prudent
macroeconomic policies, so that they do not have to report poor performance.

b. Controls on capital inflows can (1) limit total borrowing by the country to reduce the risk
of overlending and overborrowing, (2) reduce short-term borrowing if the controls are
skewed against this kind of borrowing, and (3) reduce exposure to contagion by reducing

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 the amount of loans and investments that panicked foreign lenders can pull out when a
crisis hits some other country.

10. Disagree. The IMF can make loans to governments of countries that have serious balance
of payments problems (including a national inability to borrow internationally to finance
current account deficits) or serious problems repaying government debt, especially debt
owed to foreign investors and lenders. However, these were not the problems for the
industrialized countries (including the United States) at the center of the global financial
and economic crisis. The crisis developed within the private financial sector, as financial
institutions and financial investors became unwilling to lend to each other. The IMF does
not lend to private financial institutions. The U.S. government and the governments of the
other large industrialized countries at the center of the crisis were not constrained by
inability to borrow, so there was no role for the IMF to lend to them. Instead, it was these
national governments, mostly working through their central banks, that had to take the
lead in providing support for financial institutions and financial markets to resolve the
crisis.

11. The likelihood of a banking crisis following an unexpected depreciation of the local
currency is fairly high. Banks in this country appear to have substantial exposure to
exchange rate risk. The banks are short dollars because their liabilities (the deposits)
denominated in dollars appear to be unhedged against exchange rate risk—the dollar
liabilities exceed any assets that they may have denominated in dollars. (Looked at the
other way, the banks are long the local-currency—the loans.) An unexpected devaluation of
the country’s currency would lead to large losses for the banks because the local-currency
value of their liabilities would increase. If the losses are large enough, a banking crisis is
likely. Because of the large losses, the banks would become insolvent (negative net worth)
and may have to cease functioning. Even if the banks are not immediately bankrupt,
depositors may create a run on the banks, as the depositors fear losing their deposits and try
to withdraw their deposits quickly. The banks would not be able to find sufficient funds to
pay the depositors quickly and would have to suspend payments.

12. If a default has no other effect on Puglia, its government should default when the
incremental cost of servicing the debt (interest payment plus repayment of principal)
becomes larger than the incremental inflow of funds from new loans. This occurs at the
end of year 3, so the Puglian government should default at that time.

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