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International Trade and Finance

Notes By the end of the 1990s, a handful of East European economies including Poland, Hungary, and the
Czech Republic had made successful transitions to the capitalist order. Not surprisingly each of these
countries was geographically close to the EU and had a recent tradition (prior to Soviet occupation in
the late 1940s) of industrial capitalism, including a body of contract and property law. Many of the
other successor states that emerged from the wreckage of the Soviet Union were still faring quite
badly even as the 20th century ended. The largest was Russia, which retained much of the nuclear
weaponry left by the Soviet Union.
Over the course of the 1990s, Russia’s weak government was unable to collect taxes or even to enforce
basic laws; the country was riddled with corruption and organized crime. It is no wonder that measured
output shrank steadily and that inflation was hard to control, so that at the end of the 1990s most
Russians were substantially worse off than under the old Soviet regime. In 1997, the government
managed to stabilize the ruble and reduce inflation with the help of IMF credits, and the economy
even managed to eke out a (barely) positive GDP growth rate that year. However, the government
had slowed inflation by substituting borrowing for seigniorage; neither the government’s attempts
to collect taxes or reduce spending were very successful, and the state debt therefore had ballooned.
When, in addition, the prices of oil and other key Russian commodity exports were depressed by the
crisis in Asia, investors began to fear in the spring of 1998 that the ruble, like many of the Asian
currencies the year before, was in for a steep devaluation. Interest rates on government borrowing
rose, inflating Russia’s fiscal deficit.
Despite Russia’s failure to abide by earlier IMF stabilization programs, the Fund nonetheless entered
into a new agreement with its government and provided billions to back up the ruble’s exchange
rate. The IMF feared that a Russian collapse could lead to renewed turbulence in the developing
world, as well as posing a nuclear threat if Russia decided to sell off its arsenal. In mid-August 1998,
however, the Russian government abandoned its exchange rate target; at the same time as it devalued,
it defaulted on its debts and froze international payments. The government resumed printing money
to pay its bills and within a month the ruble had lost half its value. Despite Russia’s rather small
direct relevance to the wealth of international investors, its actions set off panic in the world capital
market as investors tried to increase their liquidity by selling emerging market securities. In response,
the U.S. Federal Reserve lowered dollar interest rates sharply, possibly averting a worldwide financial
collapse. Russia’s output recovered in 1999 and growth was rapid afterward, helped by higher world
oil prices.
26.2 Lessons of Developing Country Crises

The emerging market crisis that started with Thailand’s 1997 devaluation produced what might be
called an orgy of finger-pointing. Some Westerners blamed the crisis on the policies of the Asians
themselves, especially the “crony capitalism” under which businesspeople and politicians had
excessively cozy relationships. Some Asian leaders, in turn, blamed the crisis on the machinations of
Western financiers; even Hong Kong, normally a bastion of free market sentiment, began intervening
to block what it described as a conspiracy by speculators to drive down its stock market and undermine
its currency. And almost everyone criticized the IMF, although some said it was wrong to tell countries
to try to limit the depreciation of their currencies, others that it was wrong to allow the currencies to
depreciate at all.
Nonetheless some very clear lessons emerge from a careful study of the Asian crisis and earlier
developing-country crises in Latin America and elsewhere.
1. Choosing the right exchange rate regime : It is perilous for a developing country to fix its
exchange rate unless it has the means and commitment to do so, come what may. East Asian
countries found that confidence in official exchange rate targets encouraged borrowing in foreign
currencies. When devaluation occurred nonetheless, much of the financial sector and many
corporations became insolvent as a result of extensive foreign-currency denominated debts.
The developing countries that have successfully stabilized inflation have adopted more flexible

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