Motivation: Why reason about developing countries?
- 1.
The IMF (International Monetary Fund) reports that in 2025 emerging-market and developing economies contributed 60.5% (more than half!) of world GDP on a PPP basis, a figure that has risen steadily from 41.6% in 2000.
- 2.
Developing countries are exposed to different risks compared to developed ones when participating in an open economy.
Which countries are considered developing?
There is no single universally accepted formal definition of a developing country. Developing countries are often characterized as having relatively lower GDP per capita, and lower average life expectancy at birth.
World Bank data illustrates this disparity: high-income countries had a GDP per capita of US$53,9971 (in 2025) and a life expectancy at birth of 80 years (in 2024), contrasting sharply with the figures of US$837 and 65 years in low-income countries.
Factors of production
Compared with economies that have undergone industrialization, many developing countries lack capital and skilled labor – factors of production crucial to modern industry. Some interpret this scarcity as a symptom of deeper challenges: political instability, meager legal protections for business and investment, and ill-fitting economic policies.
Structural risks
(Somewhat stylized) structural features of developing economies:
- 1.
Governments often exercise more direct influence over economic activity.
- 2.
Some have a history of high inflation explained in part by widespread tax evasion and seigniorage.
- 3.
Under-developed risk management in credit institutions.
- 4.
Under-developed legal frameworks for business and investment law. Edge cases like bankruptcy, and defaults not handled well.
- 5.
Higher prevalence of corruption.
Financial capital flows both ways, or the Lucas paradox
Basic economic theory predicts that capital should flow from rich countries to poor countries. Because capital is relatively scarce in poorer economies, its marginal return should be higher there, incentivizing investors in richer countries to lend to or invest in poorer ones.
However, sizeable flows in the opposite direction have occurred over recent decades, i.e., financial capital flow from poor to rich countries. One manifestation of this is richer countries running persistent current account (CA) deficits financed by capital inflows from relatively poorer trading partners running CA surpluses.
Original sin
The term "original sin" refers to a country's inability to borrow internationally in its own currency.
Developing countries are more likely to suffer from original sin because foreign lenders are wary of a developing country's history of severe inflation and currency depreciation.2 As a result, lenders often prefer loans and bonds to be denominated in a major foreign currency such as the U.S. dollar, euro, or yen.
In contrast, the advantages of a loan denominated in a domestic currency are: (i) that the government could simply print their own currency to repay creditors to avoid default (the disadvantage for creditors is that printing in general devalues the currency they're being repaid in); and (ii) that the government could depreciate its currency, thus reducing the real resources it owes to foreigners.
Many developing countries are net debtors in foreign currency. If their domestic currency depreciates, for example, due to a fall in export demand, the domestic currency value of their foreign currency denominated debts rise causing their debt burden to increase precisely when economic conditions are deteriorating.
Original sin is one reason developing countries accumulate sizeable international reserves which often exceed their short-term liabilities to foreigners, in order to forestall doubts about their creditworthiness. (Another possible reason is a desire to perform currency pegging, i.e. fixing exchange rates.)
Liability dollarization is the phenomenon whereby, in addition to external debt owed to foreign creditors, domestic debts between residents are also denominated in a foreign currency (which could be a currency other than the U.S. dollar). This exposes domestic borrowers to exchange rate risk. If borrowers earn their income primarily in domestic currency, a depreciation of the domestic currency strains their debt burden and heightens their risk of default.
Desire for fixed exchange rates, and the accompanying borrower moral hazard
A developing country's government may prefer fixed exchange rates (i.e., currency peg) so as to:
- 1.
Ease concerns of inflation. Pegging to a low inflation currency anchors the domestic currency to it.
- 2.
Increase policy credibility by convincing markets that it will pursue disciplined monetary policy by pegging its currency to a more credible one.
- 3.
Obtain predictability in costs and revenues in transactions involving foreign entities.
- 4.
Reduce transaction costs by reducing hedging costs related to exchange rate uncertainty.
- 5.
Protect balance sheets of domestic firms, banks, and the government if they have sizeable debts denominated in foreign currencies (recall: Original Sin). Keeping the exchange rate stable prevents the domestic currency value of those debts from rising.
Unlike a floating exchange rate where the exchange rate risk is highly visible, when a government commits to maintaining a currency peg (i.e., fixed exchange rate), borrowers perceive little exchange rate risk. As such, unhedged foreign currency borrowing proliferates.
Should the peg break when the government is no longer able to maintain the peg with their foreign currency reserves, the domestic currency depreciates rapidly, thereby causing the cost of financing the foreign currency denominated debt to rise sharply, heightening default risks, and potentially contributing to a broader debt crisis.
Moral hazard arises to the extent that borrowers take on more foreign exchange risk because they expect the government's promise of fixed exchange rates to protect them from the consequences of currency depreciation.
Sequencing reform measures
The order in which reforms are introduced can impact their outcomes.
When several distortions are present, resolving only one or a few of them does not necessarily improve welfare.3
For instance, it is widely recognized that financial account liberalization should generally come after strengthening domestic financial regulation, supervision, and risk-management institutions. The idea is that if banks are poorly regulated, allowing them easy access to foreign borrowing encourages excessive risky lending.
Absence of Income Convergence between High- and Low-Income Countries
The basic income convergence argument goes like this:
Developing countries have less capital per worker, so an extra unit of capital should earn a higher return there than in a rich country. Capital should therefore flow from rich to poor countries. At the same time, poorer countries can adopt technologies that rich countries have already developed rather than inventing everything themselves. If trade is open, technology diffuses, and capital moves freely, poorer countries should catch up.
However, in reality, this (overly simplistic) convergence is sporadic at best, with a majority of low income countries struggling to catch up to their high income counterparts.
This suggests that, in addition to the presence of rather persistent structural challenges (e.g. institutions, human capital, infrastructure, productivity, political stability), there remain risks in developing economies that are difficult to reason about and overcome.