International lending and

financial crisis
Ref: International Economics
by
Thomas A. Pugel (Chapter 21)
International Lending
International flows of financial claims can be divided
into different categories by:
• Type of lender or investor (private or official)
• Maturity (long term or short term)
• Existence of management control (foreign
direct investment) or not
• Type of borrower (private or government)

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 International Lending
A. Private lending and investing
1. Long term
• Direct investment (investing in a foreign enterprise largely
owned and controlled by the investor)
• Loans (to foreign borrowers not controlled by the lender, with
maturity of more than one year, mostly by banks)
• Portfolio investment (purchasing stocks and bonds with
maturity of more than one year, issued by a foreign
government or a foreign enterprise not controlled by the
investor)
2. Short term (lending to a foreign borrower not controlled by the
lender, or purchasing bonds issued by a foreign government or
a foreign enterprise not controlled by the investor, maturing in
one year or less)
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International Lending
B. Official lending and investing
• This can be by a government or a multilateral
institution such as IMF or the World Bank, mostly
lending, both long term and short term.

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International Lending Benefits
• It represents an intertemporal trade, in which the
lender gives up resources today in order to get
more in the future, and the borrower gets
resources today but must be willing to pay back
more in the future.
• It allows lenders and investors to diversify their
investments more broadly.

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Gains & losses from well-behaved international lending
Taxes on International Lending
• We have compared free international lending with no
international lending and have found that:
Freedom raises world product and national incomes.
• Another standard result also carries over from trade analysis: the
nationally optimal tax.
• If a country looms large enough to have power over the world
market rate of return, it can exploit this market power to its own
advantage, at the expense of other countries and the world as a
whole.

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Actual International Lending
• International lending and borrowing are often well-
behaved.
• Lender and borrower usually benefit from the
gains from intertemporal trade, as countries
with net savings get higher returns and
countries that are net borrowers pay lower
costs.
• International financial investments are used to
lower risk through portfolio diversification.
• Conflicts sometimes arise over tax policies, but
these are manageable.
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Actual International Lending
• Sometimes international lending is not well-
behaved.
• When a developing-country faces a financial
crisis, it experiences difficulties in servicing its
debts and often defaults—that is, fails to make
payments as specified in the debt agreements.
• Lenders cut back or stop new lending, as the
borrower is viewed as too risky.

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The Surge in International Lending 1974 to 1982
• Oil shocks (1970s) led to a surge in pvt international lending to devg ctys.
• Four forces combined to create the surge:
1. Rich oil-exporting countries had a high short-run propensity to save out
of their extra income
2. There was widespread pessimism about the profitability of capital
formation in industrialized countries.
3. The 1970s was an era of peak resistance to foreign direct investment
(FDI), in which the foreign investor, usually a multinational firm based in
an industrialized country, keeps controlling ownership of foreign-affiliated
enterprises.
4. “Herding” behavior meant that the lending to developing countries
acquired a momentum of its own once it began to increase.
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International Lending to Developing Countries
• The Debt Crisis of 1982 - What caused the crisis?
• Interest rates increased sharply in the United States as the U.S. Federal
Reserve shifted to a tighter monetary policy to reduce inflation.
• The U.S. and several other industrialized countries were in a severe recession.
• Developing countries’ exports declined and commodity prices fell while interest
rates remained high.
• The debtors’ ability to repay fell dramatically.
• The Resurgence of Capital Flows in the 1990s
• Majority flows to major emerging markets - Mexico, Brazil and Argentina in LatAm;
China, Indonesia, Malaysia, S Korea and Thailand in Asia

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International Lending to Developing Countries
• A series of financial crises struck the developing countries again

• The Mexican crisis 1994-95

• The Asian crisis 1997
• The Russian crisis 1998
• Argentina’s crisis 2001-02
What leads to a financial crisis?
• Overlending and overborrowing
• Exogenous international shocks
• Exchange rate risk
• International short term lending
• Global contagion
What are the effects of a financial crisis?
• Decline in access to lending
• Recession due to slowdown of economic activity
• Defaults in paying back international loans
• Declines in the market prices of bonds, stocks and loans traded
on the secondary market.
Resolving a financial crisis – Rescue packages
• Rescue packages - affected country’s govt seeks loan commitments
to help tide over the crisis – usually sought from the IMF, WB, national
govts
• Loans can compensate for the lack of pvt lending during the crisis
• Forex relief
• New financing for some domestic investment
• Cushion decline in agg dd and dom production
• Restore foreign investor confidence
• Replenishing forex reserves
• Signal official international support for the country and its govt.
• Limit contagion effects
• Conditionalities to speed the end of the financial crisis
• Tighter monetary and fiscal policies
• Structural reforms (liberalising trade, banking reforms)
Some questions about rescue packages
• Efficacy of rescue packages
• Very succesful in resolving the 1995 Mexico crisis
• Moderately succesful in resolving the 1997 Asian crisis
• Failed in some cases such as Argentina

• Do rescue packages increase the likelihood of more financial crisis as they

encourage moral hazard - overlending/overborrowing?
• Even if rescue packages encourage moral hazard, the immediate overwhelming need is
to get back the loans (for the lender) and reduce debts (for the borrower)
• When a financial crisis strikes, borrowers lose a lot even if there is a rescue package; so
much so that moral hazard does not seem too large for them
Resolving a financial crisis - Debt restructuring
• Debt restructuring – refers to bringing about changes to the
terms of debt
• Debt rescheduling – is a process wherein the terms of a loan is made
easier for the borrower who is facing current repayment difficulties,
primarily through extending the repayment period, reducing monthly
instalments or temporarily pausing payments. The amount of debt is
effectively the same.
• Debt reduction – amount of the loan to be paid back is lowered.
• A key issue in reaching a restructuring agreement between the
creditors and the borrowers is the free rider problem that might
lead to not resolving the crisis.
• Bond restructuring was problematic – collective action clauses
 Reducing the frequency of financial crises
• Reforming the ‘International financial architecture’
• Pursue sound macroeconomic policies
• Provide regular, timely and reliable data to the public on total debt and its
components and also on the reserve position.
• Avoid short term borrowing in foreign currency so as to avoid a crisis when foreign
lenders suddenly demand payment
• Bank regulation and supervision
• Some controversial proposals
• End efforts to fix/manage exchange rate vs permanently managed or fixed exchange rate
• IMF should expand its scope of activities vs IMF should be abolished
• competing proposals
• Expanding the use of capital controls to limit borrowing
 Reducing the frequency of financial crises: Bank
regulation and supervision
• Govt regulation and supervision of banks in developing countries has been
weak. As a result of weak regulation, banks tend to undertake risky
activities. Moreover, since banks operate with little equity capital, so they
are even more likely to take risks. This risk-taking nature is further
aggravated by the fact that here is an implicit or explicit guarantee that the
govt will rescue a troubled bank. Sometimes the govt itself may exert
pressure to lend to groups in which lie the economic interests of the govt.
• Some of the risky activities include
• Loans based on relationships - crony capitalism loans
• Take on large exposures to forex risk by borrowing in foreign currency and lending in
local currency
• Thus conditions are such that banks tend to borrow too much
internationally (as govt will come to their rescue anyway!) and take the risk
of unhedged foreign liabilities, triggering a potential financial crisis.
Reducing the frequency of financial crises: Bank
regulation and supervision (cont’d)
• Strong banking regulation required. These include:
• Banks should use sound accounting techniques and make relevant
information public
• Reduce risk exposure through use of solid risk assessment and risk
management techniques
• Recognize bad loans and make provision for them
• Increase equity capital
• Regulators should identify weak banks and take appropriate action on
them.
• Reforming the banking sector in a sequential way – eg. to reduce the risk
of a crisis, the cty should strengthen its financial and NBFI institutions
before it liberalises its financial account and provides easy access to
foreign currency exposures.
Reducing the frequency of financial crises: Capital controls
• Capital controls to limit capital inflow is a controversial proposal
• Can take various forms:
• An outright limit or prohibition to borrowing
• A tax to the govt (eq to a share of the borrowing) by borrowers or foreign investors
• A deposit with the central bank (eq to a share of the borrowing/foreign investment)
• How can capital controls reduce the risk of a financial crisis?
• Prevent large inflows thereby restraining overlending and overborrowing
• Discourage short term borrowings
• Can lower contagion effects by limiting the amount foreigners could pull out of the
country
• Although a measure to check financial crisis, it leads to an outright loss of
gains from international borrowing
• Overtime capital controls are likely to lose their effectiveness as investors
and borrowers find ways to circumvent them. Also govt can also make
mistakes with capital controls as happened in South Korea in 1997.