Transcript Non-convertible currencies - uwcmaastricht-econ

Financial barriers
Three types of barriers
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2.
3.
High indebtedness of developing countries
Capital flight
Non-convertible currencies
LDCs indebtedness
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Indebtedness is a country’s level of external (or
foreign) debt. It equals the total amount of debt
(public and private) incurred by borrowing from
foreign creditors.
Borrowing from foreign sources is a credit in the
financial account of the BOP and helps
countries pay for deficits in the current account.
But it has costs: ‘debt servicing’ (payment of
principal + interest).
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Consequences of high indebtedness
Debt trap. If X revenues not enough for debt
servicing→ need to borrow more → larger
debt service payments → debt becomes
unsustainable.
BOP problems due to the high levels of debt.
Lower private investment if fears that a
government may be unable to service debts.
Mainly short term investments.
Lower public investment. Less resources for
poverty alleviation and social services.
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6.
Diversion of X revenues away from needed
imports and towards debt servicing.
3, 4 and 5 → Lower economic growth
Consequences of policies intended to address
high indebtedness in LDCs. In the 80s, IMF
and World Bank intervened to avoid that some
LDCs defaulted on their loans. As a
consequence:
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Debt burden has decreased
But in some cases at the expense of economic
growth.
Policies imposed by IMF
Mainly loan restructuring (ie, granting of new
loans with longer time period and lower i ).
Requirement: meet policy requirements
imposed by the IMF.
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These were tight fiscal and monetary policies
intended to:
↓Gov spending (by reducing provision of merit
goods) and ↑gov revenues (by increasing prices of
services provided by public firms, imposition of fees
for education and health services)
o ↑Interest rates
o ↓ AD and ↓ Demand for M
This led to lower econ growth, ↑ UE and ↑ poverty.
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2.
Low success of HIPC initiative. In the 90s,
WB and IMF begun this initiative to provide
debt relief to a number of highly indebted
poor countries by cancelling a portion of their
debts. Conditions:
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Follow certain WB, IMF policies such as ↓ G and
liberalize markets.
Pursue a poverty reduction strategy.
Criticisms: Insufficient level of debt reduction,
takes effect too slowly, severity of some
measures, many highly indebted countries were
not included in the initiative.
Increased foreign control of domestic assets
due to debt-for-equity swaps.
Debt for equity swaps: a highly indebted country
exchanges a portion of its debt for equity,
which is taken up by foreign corporations. The
foreign corporation takes responsibility for a
portion of a government’s debt and in
exchange the government gives it ownership
of some of its assets. Much of Latin American
privatization occurred this way.
Problem: assests are frequently acquired at a large
discount, so control of assets is lost at a price
far lower than the market price.
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Capital flight
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Definition: Large scale transfer of privately
owned financial capital to another country.
It results from high uncertainty and risk of
holding domestic assets due to:
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Risk of confiscation
Sudden ↑ taxation
Political instability
Anything leading to loss of value of the domestic
currency.
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Problems:
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It involves a loss of financial capital that could
have been invested domestically.
Sale of domestic currency → downward pressure
on its value, forcing gov to devalue or allowing
depreciation.
Worsens external debt problem, as it involves use
of scarce foreign exchange → ↑ need for external
debt borrowing.
In Mexico in 94-95, political instability and lack of
confidence in the economy led to massive sales
of pesos, a drop in foreign reserves, massive
capital flight and devaluation of the peso.
Non-convertible currencies
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Fully convertible currency: can be freely
exchanged for other foreign currencies.
Fully non-convertible currency: cannot be
exchanged for other currencies because of
government restrictions.
Non-convertible currency: convertible only for
specified foreign transactions. It may apply to
current acount and financial account
transactions.
Many LDCs still maintain non-convertibility for
their financial accounts.
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Non-convertibility for current account
transactions (mainly foreign trade).
Conversion of currencies is subject to gov
restrictions. For example , only for specific
imports and exports consistent with gov
objectives.
Today most countries have convertible
currencies for CA transactions.
Benefits: based on the principle that Int’al
trade should be conducted in the context of
competitive mkts.
Non-convertibility for financial account
(FA) transactions. Implies gov control over
what flows are permissible. Exceptions for:
debt service payments, funds to be used in
inward FDI, inward flows due to borrowing,
financial investment by foreigners.
Benefits of non-convertibility for FA:
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a)
b)
Capital flight can be avoided, as financial capital
cannot leave the country if the domestic currency
cannot be converted into foreign currencies.
Currency speculation is also avoided.
c)
Ability to conduct monetary policy independently of
exchange rate considerations. In case of a recession, for
example, the interest rate can be lowered without risk of a
depreciation.
Conditions to be met before full convertibility.
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Stable political system
Sound fiscal and monetary policies that encourage
confidence in domestic assets and currency.
Sound macro policies that work to avoid wide exchange
rate fluctuations and large BOP deficits.
Strong financial institutions that operate under gov
regulation to avoid excessive risks.
Mkt orientation, with well-functioning price system that
facilitates more efficient allocation of resources and
financial capital.
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Benefits of full convertibility for FA:
Access to foreign capital markets (ability to
diversify financial investments).
Access to more varied and cheaper sources of
finance.
Encourages FDI.
Permits inflows of financial capital, as
foreigners know they can sell their assets if
they wish.
↑ competition among financial institutions →
↑ efficiency + ↓ costs.
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Prevents black market for foreign exchange
1 to 6 contribute to greater economic growth.
Facilitates efficient global allocation of savings.
Currency convertibility and financial crises.
Several East Asian countries experienced a severe financial and
economic crisis in the late 90s. These economies had extended
convertibility of their currencies to the FA (under pressure from
the IMF).
In 1997, recession + declining confidence in the economy triggered
attacks on their currencies, resulting in massive capital flight and
downward pressures on the value of their currencies.
IMF stepped in with loans and imposed tight monetary policy in
order to curtail capital flight and help support the currencies.
However, confidence was low and downward pressure on curr
continued. High i created negative growth, higher UE and
poverty.
According to Stiglitz, FA liberalization ‘...was the single most
important factor leading to the crisis’.
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