Balance of payments crisis in an external debt led growth regime

Balanceofpaymentscrisisinanexternal
debt-ledgrowthregime

YannickKalantzis
∗
(CEPREMAP,ENPC)
Version:May7,2004

Abstract
Westudythelong-runeffectofcapitalaccountliberalizationus-
ingthemodelofasmallopeneconomywithtwosectors.Inthecase
ofalowtechnologicallevel,thelong-runevolutionoftheproductive
structurethatfollowstheliberalizationleadsto
financialfragility
by
creatingtheconditionsunderwhichbalanceofpaymentscrisesare
possible.Highercapitalinflowsbothhaveastabilizingandadestabi-
lizingeffect,theiroveralleffectdependingontherelativetechnological
levelofeachsector.

1Introduction
Whataretheeffectsofcapitalaccountliberalizationondevelopingcountries?
Thelasttwentyyearshavewitnessednumerousbalanceofpayments(BoP)
crises,oftencoupledwithbankingcrises,indevelopingcountriesthathad
previouslyopenedtheireconomytoforeigncapitalflows.Thesouthcone
crisesatthebeginningoftheeighties,theMexicancrisisof1994,theAsian
∗
CEPREMAP.48,bdJourdan75014Paris.France.
E-mail:
yannick.kalantzis@cepremap.cnrs.fr

1

crisesof1997andtheArgentinecrisisof2001wereallprecededbymassive
capitalinflows.Amongthehugeliteraturededicatedtotheempiricalanalysis
ofthoseevents,severalworkshaveshownthatcapitalinflowswerelikelyto
initiateaboom-bustcyclethatcoulddramaticallyendinaseveretwincrisis.
1
Eveniftheopeningofthecapitalaccountmaybeattheoriginofthecycle,
somepapersinsistontheamplifyingroleplayedbythedomesticfinancial
system,particularlythebankingsystem(Herna´ndez&Landerretche1999).
Boom-bustcyclesarethusassociatedwithacyclicalevolutionofbankcredit
andthecredit/GDPratiostronglyincreasesinthefewyearsprecedingthe
crisis.
Allthesepapersshowagrowingconsensusastothepossiblydestabilizing
short-runeffectofcapitalinflowstodevelopingcountries,butthequestion
oftheirlong-runeffectisstillsubjecttodebate.Amongthefactorsthat
areattheoriginofthecycles,pro-cyclicalrisk-takingofentrepreneursand
externalcreditorscouldeventuallybecomelesspronouncedasagentslearn
fromtheirerrors,andtheimperfectprudentialregulationofthebanking
systemmightbeimprovedaftersometimebythemonetaryauthorities.
Kaminsky&Schmukler(2003)givereasonsforoptimismastheyobservethat
financialliberalizationincreasestheamplitudeofboom-bustcyclesinthe
stockmarketintheshort-runbutdecreasesitinthelong-run.Theysuggest
financialliberalizationmightcreatethenecessaryincentivestoimplement
institutionalreformsthatwouldstabilizetheeconomyintheend.Onthe
contrary,fourhundredyearsoffinancialcrisesleadRodrik(1998)toconsider
thatboom-bustcycles“arethemainstory”.Distortionsandanomaliesare
theusuallotoffinancialmarketssothatthedebateshouldbeledina
worldofsecond-bestpolicy,wherecapitalaccountconvertibilitymightnot
beanadequatepolicyfordevelopingcountries.Theargument,asitgoes,
1
Forthepositivelinkbetweencapitalinflowsandlendingboomsindevelopingcoun-
tries,seeHerna´ndez&Landerretche(1999)andGourinchas,Valde´s&Landerretche
(2001).Lendingboomsaregoodpredictorsoftwincrises(Kaminsky&Reinhart1999,Tor-
nell&Westermann2002)althoughthetypicallendingboomusuallyendsupwithasoft
landing.

2

isthatthereisnoevidencedevelopingcountrieswithoutcapitalcontrols
outperformothers,
2
whereasthedangersofcapitalaccountliberalizationare
clearlystated.AccordingtoWyplosz(2001),capitalaccountliberalization
shouldultimatelybeafirst-bestpolicy,althoughitsbenefitsmightbeof
secondorder,butitshouldonlybeimplementedonceapropereconomic
infrastructureisinplace(thatis,oncethedevelopingcountryhasbecomea
developedone),anevolutionwhichmighttakedecades.
Thispaperisatheoreticalcontributiontothedebate.Westudythe
long-runeffectofcapitalaccountliberalizationinasmallopendeveloping
economy.Todothis,weconsiderthefinancialopeningasinducingatransi-
tionfromastationarystatewithoutmovementsofcapitalandwithamoder-
ategrowthratetoanotherstationarystatewithcontinuouscapitalinflows,
ahighergrowthrateandnonzeroexternaldebtratios(aslongasnocrisis
occur).Wedubthelatter
externaldebt-ledgrowthregime
.Weshowthatbal-
anceofpaymentscrisesmayoccurinthisnewstationarystate,dependingon
thestructuralcharacteristicsoftheeconomy.Ourmainfindingistherefore
thatcapitalaccountliberalizationhasdifferenteffectsondifferenteconomies:
veryproductiveoneswillbenefitwithoutdangerfromexternalsavingsfu-
ellingasteadiercapitalaccumulation,whilelessproductiveeconomieswill
alsoexperiencehighergrowthratesduringtranquiltimes,butatthecost
ofpossibleBoPcrises.Wealsoshowthatadeeperintegrationintointerna-
tionalfinance(inthesenseoflargercapitalinflows)can,asthecasemaybe,
strengthenthisfragilityor,onthecontrary,reduceit.

Webuildthemodelofasmallopeneconomy,withtwosectors,produc-
ingstandardizedcommoditiesfortheworldmarketsandanon-tradedgood.
Becausethereisnointra-sectorialcapitalmobilityintheshortrun,foreign
capitalinflows(corporateexternaldebt)leadtoarealappreciationwhich
manifestsitselfbyariseintherelativepriceofnon-tradedgoodswithre-
2
Thereisnowawideempiricalliteratureonthecorrelationbetweencapitalcontrols
andlong-termgrowth.SeeArteta,Eichengreen&Wyplosz(2001)forarecentandcritical
workonthesubject.

3

gardtotradedgoods.Inthelongrun,therelativesizeofthenon-tradable
sectorincreases,sothattherealexchangerateisbroughtbacktoitslong-
runequilibriumvalue.
3
Thus,therearetwodifferenttime-scales:theshort
time-scaleofpricemovements,capitalinflowsandoutflowsandinvestment
decisions,contrastingwiththelongertime-scaleofcapitalaccumulationand
changesinitssectorialcomposition.Astheadjustmentsoftheproductive
structureareslow,suddenvariationsofpricesandinvestmentarelikelyto
occurintheshortrun,therebymakingcrisespossible.
Theprecisemechanismofthecrisisinvolvesmultipleequilibria.Onthe
onehand,astopintheinvestmentofthenon-tradablesectorreversesthe
capitalflowstothatsectorandprovokesarealdepreciation.Ontheother
hand,arealdepreciationdiminishestheprofitabilityofthenon-tradablesec-
torandleadstoastopintheinvestmentofthissector
4
ifitissufficientlylarge.
DuringaBoPcrisis,thestopintheinvestmentofthenon-tradablesector
andtherealdepreciationoccursimultaneouslyandvalidateeachother.
5
The
momentatwhichthechangeofequilibriumwilloccurisofcourseimpossible
topredict;butwecanneverthelessexaminetheconditionunderwhichmul-
tipleequilibriaarise.Thisconditiondependsonstructuralfeaturesofthe
economy,mainlythesectorialcompositionofcapitalwhichevolvesinthe
longrun.Thus,themodelallowsustodeterminewhethertheendogenous
long-runevolutionoftheeconomyeventuallycreates,ornot,theconditions
underwhichacrisisbecomespossible.
Asouraimistodiscussthepossibilityofcrisesinthenewgrowthregime
ledbyexternaldebt,independentlyofshort-runcyclicalfluctuations,the
modelexcludesfactorsthatcouldoriginateacreditcycle.
6
Forinstance,to
3
Thismechanismissimilartotheonestudiedbytheso-called
Dutchdisease
literature.
SeeforinstanceBruno&Sachs(1982).
4
Thismechanismrequirestheinvestmentdecisionstobetakenwithashorttimehori-
.noz5
Thepaperdoesnotdealwithsuddenstopsincapitalinflows,althoughtheframework
developedherecouldeasilybeusedtoassessthevulnerabilityofadevelopingeconomyto
suchanexogenousshock.
6
Wedonotdenytheexistenceandrelevanceofthesecycles,butourpointistoconstruct

4

avoidover-indebtednessandover-investment,theexternaldebtisentirely
collateralizedandrisk-less,andacreditconstraintlimitstheinvestment.

Thestylizedfactsreproducedbythemodelarequalitativelyconsistent
withtheempiricalevidencethathasbeendocumentedinseveralpapers.The
realexchangerateappreciationwhichoccursinthephaseofrapidgrowthpre-
cedingthecrisesisawell-establishedfact(Kaminsky&Reinhart1999,Gour-
inchasetal.2001,Tornell&Westermann2002).Thisrealappreciationis
verylikelytobepartlytheresultfromthemassivecapitalinflows,although
thismightbetruerofLatinAmericathanofAsiancountries(Calvo,Leider-
mann&Reinhart1996,Athukorala&Rajapatirana2003).Theasymmetrical
evolutionofthetwosectorswasempiricallyobservedbyTornell&Wester-
mann(2002).Inaneventstudyoftwincrises,theyobservethattherelative
sizeofthenon-tradablesectorwithregardtothetradablesectorincreases
beforethecrisesanddecreasesafter.Thissectorialasymmetrymaybethe
consequenceofdifferencesinprofitability.Ros&Lustig(2000)providedata
onarelativeprofitsqueezeintheMexicantradablesectorwithregardto
thenon-tradablesectorbetween1987and1994.Themodelalsoempha-
sizesthecentralroleplayedbyinvestmentinthecrisismechanism.Thisis
consistentwiththefactthatinvestmentisthecomponentofGDPdisplay-
ingthelargestvariabilityinthecrisesepisodes,growingrapidlybeforeand
fallingabruptlyduringthecrisis,contrarytoconsumptionwhichremains
rathersmooth(Gourinchasetal.2001,Tornell&Westermann2002).At
last,thecrisesareoftenunpredictedandsurprising,afactaccountedforby
ourmultipleequilibriastory.

Thispaperisrelatedtothetheoreticalliteraturethattriestomodel
theinstabilityofemergingmarketsandtheBoPcrisesfollowingperiodsof
atheoreticalframeworkfromwhichtheyare
apriori
excluded.Thecriseswedescribedo
notendaphase