Tag Archives: Latin America

China and the Debt Crisis

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Sri Lanka is not the first developing economy to default on its foreign debt, and certainly won’t be the last. The Economist has identified 53 countries as most vulnerable to a combination of “heavy debt burdens, slowing global growth and tightening financial conditions.” The response of China to what will be a rolling series of restructurings and write-downs will reveal much about its position in the 21st century international financial system.

Debt crises are (unfortunately) perennial events. In the 1970s many developing countries, particularly in Latin America, borrowed from international banks to pay energy bills that had escalated after oil price increases enacted by the Organization of Petroleum Countries (OPEC). Repaying those loans became more difficult after the Federal Reserve raised interest rates in 1979 to combat U.S. inflation. Mexico announced that it could no longer make debt payments in August 1982, and other governments soon followed (see here for more detail).

The U.S. government supported negotiations that brought together the governments unable to make payments, the banks that had made the loans, and the International Monetary Fund. The banks were willing to restructure the debt while the IMF lent funds to the governments that allowed them to keep up their interest payments while staving off acknowledging their inability to pay off the debt. But this only delayed a final resolution of the crisis and led to a “lost decade” in Latin America. In 1989 Secretary of the Treasury Nicholas Brady proposed a plan that led to reductions of the loan principals in return for the issuance of “Brady bonds” by the debtor governments.

The U.S. allowed the IMF to take the lead during subsequent crises, including the East Asian crisis of 1997-98, Russia in 1998 and Argentina in 2000. As the member with the largest quota, the U.S. could influence the design and implementation of the IMF’s programs. It also took a more active role when U.S. interests were directly affected, as it did with Mexico in 1994-95. While U.S. attention was focused on its own crisis in 2008-09, the IMF took on the task of lending to middle- and low-income countries that were caught up in the economic shock waves of the financial collapse. The Federal Reserve, however, established currency swap lines with the central banks of other advanced economies as well as those of four emerging markets: Brazil, South Korea, Mexico and Singapore.  The Fed reactivated the swap lines in March 2020 in response to the disruption in international credit markets caused by the pandemic and also set up a new facility to provide dollar funding to foreign official institutions.

China has taken a different position with regards to the debt of developing nations. Its state-owned banks have made bilateral loans as part of the Belt and Road initiative, with many of these loans made to African governments for infrastructure projects. But the amount of lending and the terms have not always been made transparent. Sebastian Horn of the University of Munich, Carmen Reinhart, currently Chief Economist at the World Bank while on leave from Harvard University’s Kennedy School, and Christoph Trebesch of the Kiel Institute for the World Economy developed a database of Chinese lending over the period of 1949-2017 which they published in a 2021 NBER paper, “China’s Overseas Lending.” They found “…that a substantial portion of China’s overseas lending goes unreported and that the volume of “hidden” lending has grown to more than 200 billion USD as of 2016.” Another study from AidData, a research lab at William & Mary, also documented Chinese lending to low- and middle-income countries, and found that many loans are collateralized against future commodity export receipts.

Some of these loans have already been restructured, with China pushing back repayment dates. If there is a systemic wave of defaults, the Chinese government must decide whether it will continue to negotiate directly with the governments that borrowed, or whether it will join the governments that belong to the Paris Club, a group of official creditors that attempt to devise sustainable solutions to debt problems, in designing a mechanism to reduce the volume of debt.

In 2020, the Group of 30 working with the IMF and the World Bank instituted the Debt Service Initiative (DSSI), which suspended debt service payments from low-income countries to official creditors, including China. Forty-eight countries participated in the program, which ended in December 2021.  The DSSI has been followed by the Common Framework, which brings together official creditors and low-income borrowers to provide some form of assistance to insolvent nations. However, private lenders have not agreed to participate and only three nations have requested relief through the Common Framework. There are concerns about the process, and there will undoubtedly be calls for broad-based debt cancellation as countries with mounting food and energy bills seek relief.

The decisions that China makes regarding its participation in new initiatives have implications for its future role in the international financial system. The government has sought to enhance the role of its currency, the renminbi, and its share in the foreign exchange reserves of central banks has risen as trade with China has grown. Serkan Arslanalp of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have documented the decline in the relative share of dollar-denominated foreign reserves and the increase in renminbi-denominated reserves in “The Stealth Erosion of Dollar Dominance and the Rise of Nontraditional Reserve Currencies” in the Journal of International Economics (working paper here). They find, however, that the changes in the composition of foreign reserves involve more than the Chinese currency, and show increases in the relative shares of the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish krona as wells. They attribute these changes in part to more active management of reserves by central bankers and also the existence of more liquid foreign exchange markets that facilitate non-dollar trading.

The use of the dollar-based international financial system as a financial weapon against Russia, including seizure of more than $300 billion of its central bank assets, could be an opportunity for another system to take its place, and there has been much speculation about the emergence of a Chinese-based rival. But Adam Tooze of Columbia University has pointed out that

“It (the dollar system) is a sprawling, resilient network of state-backed, commercially driven, profit-orientated transactions, lubricated by the easy availability of dollars, interwoven with American geopolitical influence, a repeated game in which intelligent players continuously gauge their advantages and disadvantages and the (very few) alternatives open to them and then, when all is said and done, again and again come back for more.”

A new system would take years to establish. Whether China’s government wants to allow its financial markets to become enmeshed in a global system by removing the remaining capital controls is unclear. The combination of drought, COVID-19 and its real estate crisis fully occupy the attention of the Chinese government. It may have to deal with a debt crisis among the developing nations however, and its response will be monitored for signs of how it sees its position within the global financial network of rules and institutions.

Economic Consequences of Populism

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Who is the true populist: Bernie Sanders, who promises single-payer health care and college without tuition, or Donald Trump, who campaigned on a promise to “drain the swamp”?  Jeremy Corbyn of the UK’s Labour Party, who wants to nationalize public-sector firms, or Marine Le Pen of France’s National Front, who wants to take France out of the Eurozone? And what would be the consequences of their policies?

To answer these questions requires first an understanding of populism. One definition of populism, such as the one found here, refers to it as policies for the “common people.” Populism, therefore, divides the world into two groups: the good “common people” and the evil “them.” “They” deprive the “people” of the rewards of their hard work and exclude them from the political process. But just who are these “common people”? And who are not?

Dani Rodrik of Harvard’s Kennedy School in one recent paper and a second coauthored with Sharun Mukand of the University of Warwick proposes an analytical framework for understanding the different strands of nationalism. Rodrik and Mukand suggest that populist politicians obtain support by exploiting divisions within a society, and envisage two kinds of separation. The first is an ethno-national split, such as occurred in Europe in the 1930s and again in modern-day Europe, and is usually associated with right-wing movements. The second is a partition by economic class, as seen in the U.S. in the 1890s, Peron’s Argentina and contemporary Venezuela, and is often found in left-wing organizations.

Under this classification, Trump and Le Pen are nationalist populists while Sanders and Corbyn have a class-based agenda. Once we understand this demarcation, we can see they will advocate different policies. The nationalist populists are suspicious of all foreign contact. They regard trade pacts as zero-sum transactions: one side to an agreement wins, and the other loses. Similarly, immigrants hurt native workers and impose fiscal costs on society. These populists are in favor of government expenditures for the “people,” but not anyone else. They favor domestic firms and will support measures to benefit them.

Class-based populists, on the other hand, are concerned about the “workers,” who includeindustrial laborers and farmers. They are suspicious of property owners and the financial sector. They seek to use taxes and other measures to redistribute property. They may also advocate government control of the economy through public ownership or the use of licenses and other means to guide production. They can grant subsidies for the purchase of basic needs, such as food or fuel. They will oppose foreigners if they are seen as allied with domestic financiers.

Initially, populist measures of either type may lead to prosperity, as more domestic and/or government spending leads to more jobs. But less efficient firms are subsidized, which increases costs. Over time these costs must be paid, as well as those made directly to households. If the bond markets are reluctant to finance government budget deficits (except at very high interest rates), the government may turn to the central bank to finance its expenditures. But the resulting inflation leads to more spending and monetary creation. A country with a fixed exchange rate, like several in Latin America, eventually runs out of foreign exchange. The resulting crises are blamed on “foreigners” or “capitalists,” and eventually may lead to a collapse.

Rudiger Dornbusch and Sebastian Edwards (currently at UCLA’s Andersen School of Management) wrote an analysis of the populist policies of Latin American governments that appeared in the Journal of Development Economics in 1990 (see working paper here). In their view:

“We mean by “populism” an approach to economics that emphasizes growth and income redistribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.…populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups who were supposed to be favored.”

The most prominent manifestations of President Trump’s nationalist populism have come in the negotiations over NAFTA  and the administration’s refusal to abide by the decisions of the World Trade Organization. In addition, there are its policies that affect illegal immigrants and its support of measures to cut legal migration. None of these will lead to an immediate crisis in the U.S.  economy, but they will have long-run consequences for the growth of the economy. Moreover, the law of unintended consequences has a wide reach, The Trump administration may find that retaliation can sting.

 

To fix or not to fix: Jeffry Frieden’s “Currency Politics”

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The decision by the Swiss National Bank to abandon its peg to the euro serves as an example of the relatively limited life spans of fixed exchange rate regimes. While the fragility of exchange rate commitments has been known since the publication of a 1995 paper by Obstfeld and Rogoff, the question of why some central banks fix the value of their currencies and others do not is less well understood. Jeffry Frieden’s Currency Politics provides a thoughtful guide to the political economy of exchange rate policy.

Frieden, the Stanfield Professor of International Peace at Harvard’s Department of Government, analyzes the decisions on the choice of exchange rate regime and also the level of the exchange rate. There is rarely a consensus within a country on these issues, and the position of the domestic parties depends on how they are affected by fluctuations in the exchange rate. The principal supporters of a fixed rate will be those who are exposed to substantial foreign exchange rate risk in their global activities, such as financial institutions and multinational corporations. Those who have borrowed in a foreign currency will also have a stake in keeping the domestic value of their debt fixed. Producers of tradable goods tied largely to world prices, such as commodities and standardized manufactured goods, will favor a depreciated exchange rate, as will those who use nontradable goods as inputs. While decisions over the choice of regime and the level of a currency’s value are conceptually separate, Frieden writes that the politics usually lead to a split between those who favor a fixed rate versus those who seek a depreciation.

Frieden tests these hypotheses with data from a range of historical experiences: the U.S. from the Civil War through the end of the 20th century, Europe during the period from the end of the Bretton Woods regime to the introduction of the euro, and Latin America from 1970 to 2010. He uses both qualitative and quantitative analysis in these sections of the book, and his use of data from the earlier periods is particularly skillful. The results show that a consideration of exchange rate-related issues sheds light on the divisions that exist over policies, and can lead to revised views of accepted versions of history.

In the case of the U.S., for example, Frieden breaks the post-Civil War era into the 1862-79 period, when the U.S. returned to the gold standard, and the period of 1880-96, when the gold standard came under attack from the Populist movement. In the first era, those business and financial interests who were most exposed to currency volatility sought to resume the linkage to gold that had been broken in order to finance the Civil War. They were opposed by tradable good producers, including many (but not all) manufacturers, farmers and miners. After 1873, the political divisions centered on whether the U.S. would go on a bimetallic standard of gold and silver, or base the dollar solely on gold. Frieden uses Congressional voting patterns to test whether economic divisions were reflected in Congressional voting on measures related to currency policy. The results generally confirm the influence of the interests he suggests were governing factors. For example, Congressional districts from New England and Pennsylvania, which included manufacturers who competed with foreign producers, were more likely to oppose measures that would return the U.S. to the gold standard. Similarly, representatives of farm products that were exported also opposed a return to gold, while other farming districts tended to support it.

The return of the U.S. to the gold standard in 1879 did not end the dispute. Falling agricultural prices prompted farmers to agitate for a bimetallic regime that would lead to a devaluation of the dollar. Miners concentrated in the Rocky Mountains also supported the use of silver. Manufacturers, on the other hand, abandoned the anti-gold movement as they were protected by high tariffs.  Frieden’s empirical analysis of votes on monetary measures between 1892-95 shows that debt, which has often been viewed as the source of farmers’ concerns, did not sway representatives to vote against gold; indeed, the districts with the largest debt levels were pro-gold. But representatives of export-oriented farm districts were more likely to vote against the gold standard. The People’s Party (the “Populists”) united the farmers, miners and other groups in supporting a bimetallic standard, and in 1896 joined the Democratic Party in supporting William Jennings Bryant for President. Bryant’s loss, followed by a second loss in 1900, signaled the end of organized opposition to the gold standard.

Frieden undertakes similar analyses of depreciation and variation in European exchange rates between 1973-94 and reports evidence supporting the argument that producers exposed to currency risk favored stability, while tradable producers preferred flexibility. Similarly, an analysis of the determinants of Latin American choices of exchange rate regime between 1960 and 2010 finds that the more open economies favor fixed exchange rates. However, manufacturers in the more open economies preferred flexibility.

Frieden convincingly demonstrates, therefore, that exchange rate policy is governed by distributional concerns. Different interests take opposing sides over whether a fixed or flexible regime will be chosen, and whether it will be used as a policy tool to favor domestic producers. The relative influence of the competing interest groups can change over time.  An increase in trade or financial openness, for example, can lead to a new alignment of parties.

Can these considerations be applied to the Swiss case? The dropping of the currency peg discomforted both those who favored a fixed rate and those who will be adversely affected by the subsequent appreciation. But the Swiss central bank must be concerned about the impact of the European Central Bank’s policy of quantitative easing, which would require further intervention and the accumulation of more foreign exchange. The Swiss move may be more of a tactical maneuver during a volatile period than a strategic change in policy. However, those Swiss firms who will see their profits from foreign sales plummet will not be quiescent about the new regime.