Fault Lines: How Hidden Fractures Still Threaten the World Economy

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan

Book: Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan Read Free Book Online
Authors: Raghuram G. Rajan
currency or to pile on more and more debt on existing debt, thus eroding its value—foreign lenders take precautions. They demand repayment in foreign currency (which is not affected by the country’s ability to inflate or devalue its currency), and they shorten the terms of their loans in proportion to the country’s indebtedness, so that they can pull their loans at short notice.
    Instead of controlling its spending, therefore, the populist government that has exhausted its ability to borrow domestically turns to foreign lenders to finance it. Thus the circumstances in which foreign loans are made are not propitious. Knowing this, foreign lenders demand protection, which the government can typically give only by eroding the rights of existing domestic creditors—for instance, the more the overindebted government borrows in foreign currency, the higher the inflation it will eventually have to generate to erode domestic-debt claims on it. Moreover, because foreign investors make short-term loans, any adverse political development may scare them into refusing to refinance the government. Even more problematic, a substantial improvement in opportunities in their home countries—such as a rise in interest rates—can cause foreign investors to pull their money out en masse. 6
    All these factors were at play in the Mexican crisis of 1994. The
sexenio,
or six-year administration, of President Carlos Salinas de Gortari was coming to an end. In the traditional fashion of the dominant party, the Partido Revolucionario Institucional (PRI), he launched a spending splurge to keep voters happy. Domestic savings dropped by 3.3 percent of GDP between 1991 and 1994, with much of it accounted for by an increase in government spending, leading to a current-account deficit that touched 7 percent of GDP in 2004. Even while the need for foreign financing mounted, political developments took a turn for the worse. In Chiapas, aggrieved peasants rose up in an armed rebellion against the government, and later in the year, the PRI’s presidential candidate, Donaldo Colosio, was assassinated. Moreover, the Federal Reserve of the United States raised interest rates throughout 1994, from 3 percent to 5.5 percent, giving investors the incentive to bring their money back to the United States.
    As foreign investors became more worried about financing the Mexican current-account deficit, the government started converting its short-term peso-denominated debt into
tesobonos
—short-term bonds that were indexed to the dollar-peso exchange rate and would protect investors from a devaluation. But as political uncertainty increased, even this was not protection enough. Investors started selling out, converting their pesos into dollars, and departing the country. The central bank’s exchange reserves became depleted, and the new president, Ernesto Zedillo, had a full-blown crisis on his hands when he entered office. Eventually, an enormous loan was put together by the U.S. Treasury and the IMF to prevent Mexico from defaulting on its debts. Investors in the
tesobonos
were paid back, but the country went through a wrenching crisis, and those who held on to peso-denominated debt suffered heavy losses.
    The 1994 Mexican crisis was a classic populist emerging-market crisis, driven by excessive government spending. The 1998 East Asian crisis was different, first because the crisis stemmed from excessive investment by countries that did save considerable amounts, and second because in many countries, the domestic private sector was centrally at fault. To understand what happened, we need to examine corporate investment in a producer-biased economy.

Corporate Investment and Managed Capitalism
     
    I argue above that bank funds are costly in a producer-biased economy, despite the subsidies offered to favored borrowers. In these economies, new corporate investment is most easily financed by resources that are produced by the corporations themselves—funds

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