Faiez Hassan Seyal | Authored during M.A. (Public Economics) degree between 1987-1989

Introduction

In this age of rapid growth and development in every walk of life, it is very difficult, rather impossible for a country to finance all of its development expenditures with its own resources. Therefore, to cover up the gap between its expenditures and revenues, it has to borrow somehow from internal and external resources. This practice is normal in certain limits but from the last few decades, we notice an extraordinary debt growth in all the countries generally, and less developed countries in particular. The purpose of this paper is to elaborate the origin and impact of the external debt on the developing economies.

The Emergence of the Debt

In last few years most major types of debt have grown rapidly. The basic reason for this rapid growth of indebtedness was the high deficits in the federal budgets. Not only this, but in addition, corporate and household debts have also increased. The problem of high debt growth in LDC’s is not a small one. Many efforts by IMF (International Monetary Fund) are in progress to help the LDC’s but the results are not quite hopeful. The LDC’s are going deeper and deeper in debt. Even the debt servicing obligations are met with more and more debt. This condition is being called “Debt Trap Peonage” by Chinweizu.[1]

Chinweizu (1985) says that in classic peonage, a worker, though legally free is held by his master. Because his wage is too low to buy the necessities of the life, the master keeps on granting him the credit but restricts the worker to buy overpriced goods from master’s own store. As a result of this, each month the peon goes deeper and deeper into debt. As long as the peon is alive, he cannot pay off his debt therefore he must continue working for his master and that is what his master wants. The master’s aim is neither to starve the peon nor to see him free from the chain of debt, but rather to keep him working until he dies. The peon cannot even run because the law will enforce him to pay back the loans before he goes anywhere else.

The third world countries, accumulating massive debts, are in the same situation. They do not earn enough from the exports of their mineral and agricultural products to pay for the expensive finished goods they import. The developed nations, through international banks and government aid, lend them the difference. Each year they need more and more loans to make up their deficits, and so their debt goes on accumulating. These less developed countries are obliged to supply their low priced raw materials to their rich creditors and are unable to utilize their resources for developing their own economies.

It is no gainsaying the fact that some of the LDC’s are even having problems with their debt service obligations; they may even default, which can worsen the situation. The seriousness of the problem can be seen from the fact that LDC’s debt to commercial banks increased to $ 460 billion in 1983 as compared to $ 160 billion in 1979.[2] Several reasons are given for high growth of LDC’s debt but, 1) deficit in the budgets, 2) capital flight, 3) foreign exchange problems and 4) high interest rate, are important. First of all, deficit in the federal budgets originates when the federal revenues are less than federal expenditures. Nearly all of the LDC’s are facing this problem. Federal revenues and expenditures of ten major LDC debtors can be seen in the table below.

Central Govt. Expenditures and Revenues of Selected Countries

Source:     Adapted from World Development Reports — 1973, 1986, 1987 and 1988.

Second reason for the high growth of debt is the capital flight. Many LDC’s kept their exchange rates too high in late 70’s and early 80’s, so as a result there was a capital flight of $ 70 billion from Latin American countries only in early 80’s.[3] The figure for all LDC’s was much higher.

The third major reason is the shortage of foreign exchange. Due to high deficits in balance of payments, most of the LDC’s have to borrow from abroad to finance their projects. Fourthly, in the early 1980’s, inflation fell sharply but nominal interest rates remained high as 11 % in 1982. In this condition nobody wanted to borrow but most of the LDC’s had to borrow to pay their old debts and for their interest payments. Before 1979, five major LDC’s debtors (Brazil, Mexico, Venezuela, Spain, and Argentina) owed about half of the total external debt. They did not have any problems in meeting their debt service obligations. But in 1980, a number of LDC’s faced serious difficulties to repay their debts. By the end of 1982, LDC’s debt increased to a substantial level as given in the tables below:

External debt and Debt/GDP Ratios of Capital Importing Countries

Source:     IMF’ World Outlook, 1978, 1982 and 1985 specially April 1986.

Growth of Total External Debt of Ten Largest Debtors (1973 – 1982) (Billions of U.S. Dollars)

Source: World Development Reports 1975 and 1977 – 1983 and IMF International Financial Statistics 1974, 1976, 1979 and 1983.

External Debt of Non-Oil Developing Countries (1973 – 1982) (Billions of U.S. Dollars and Percentage)

Source:     Data collected from IMF World Economic Outlook, (1974 — 1983)

A major crisis started in 1982 and 1983, when large debtors’ countries (Brazil and Argentina) started defaulting in their debt payments. Indeed many of the LDC’s had only one choice and that was to default their debt obligations as many of them did in 1930’s. By 1986, nearly forty of the LDC’s including all Latin American countries were forced to default in their debt obligations. The outflow of capital was at substantial levels in 1985 when LDC’s paid nearly $ 50 billion in interest alone to overseas creditors and this was $ 22 billion more than the loan they received in this year.[4]

After examining the growth of debt during 70’s and early 80’s and having a look at the circumstances which caused the crisis during early 80’s, now there was a need to discuss some other factors which caused the high growth rate of debt in addition to those already discussed. One most important reason of debt growth was the rise in the oil prices in 1973-1974 and 1979-1980, followed by high real interest rates in 1980-1982 as discussed in the table below:

Impact of Oil Prices on the Debt of Non-Oil Producing LDC’S (1973 – 1982) (Billions of U.S. Dollars)

Source:     IMF’ World Economic Outlook, 1976 – 1979 and 1983.

Effects of Foreign Debt

A developing nation has to use all of the available and possible resources to raise funds for the implementation of its development plans. It has to utilize surplus revenues, tax revenues, seek for external aid and borrow in addition. Public borrowing can be domestic or foreign. In LDC’s savings are too low, therefore LDC’s government has to borrow from abroad. Foreign debt has two dimensions, on one hand it is helpful in the development process and on the other hand, excessive borrowing can cause many serious problems.

On the first instance, foreign loans help to bridge up the gap between govt. expenditures and revenues which may not be covered by domestic savings. Secondly, foreign debt help the economy to import the capital goods, machinery and technology for investment purposes which is sometimes impossible for the LDC’s without the foreign aid, and is necessary for the development plans. Thirdly, foreign debt can be used for export promotion or import substitution industries, which can help in reducing the dependency on foreign debt in future. On the other hand, external debt transfers wealth when the loans are repaid with the interest. External debt also cause direct burden on the community because of the raised taxes by the government to generate additional revenues for the debt servicing. Because of the fact that debt is to be paid by future income, it reduces future savings. Lastly, in addition to all of these factors, political strings attached with loans as called “Debt Trap Peonage” by Chinweizu, destroy the independence of the country. Foreign debt can affect the economy by changing consumption, investment, savings and income levels. Nature of the effects depends upon the use of debt.

Effects on Consumption and Spending: – Foreign debt has two sided effects on consumption and spending. On one hand, government of debtor country spends more to complete its projects. More money means more income and more income means more consumption. If the aggregate supply is not enough to satisfy the increased aggregate demand, it will create inflation in the country. On the other hand it has indirect negative effect on consumption. We know that debt is a burden that requires higher taxes to meet indirect payments; therefore more taxes will leave less disposable income which will reduce the consumption too.

Effects on Savings: – Effects of foreign debt again depends upon the use of debt. If the debt is used to finance the investment which will further increase the income of the people, then savings will increase out of increased income. On the other hand, if it is used on non-productive projects, it will depress savings by increasing aggregate demand and creating inflation.

Effects on Investment: – If foreign debt is used for capital investment, it will further increase the private domestic investment, because increased aggregate supply will balance the increased aggregate demand, caused by the increased income. On the other hand, increased expenditures on nonproductive projects will cause higher interest rates which will depress incentives for investments.

Effects on Monetary Policy: – If the borrowed money is spent on non-productive issues, the new expenditures will shift the IS curve upward, increasing the deficit and causing higher interest rates with reduce investment. Therefore Federal Bank will increase the money supply, (to offset the additional demand created by shift in IS curve) therefore LM curve will move forward, causing new equilibrium with the interest rates at its initial levels but at higher income and output level. If federal bank does not increase the money supply, additional demand created by increased expenditures will cause inflation.

 Effects on Financial System: – By 1982, 50 % of the total debt of the LDC’s was owned by the commercial banks. Given the importance of the financial system of the world, there could be a great loss of capital for these banks in the case of default by the debtor countries. Exposure of the commercial banks is clear from the table below.[5]

Exposure of 9 Largest U.S. Banks in Non-Oil Producing LDC’s (relative to capital in percentage)

Source:     U.S. Federal Reserve Board, Country Exposure Lending Survey Report 1979, 1981 and 1983.

In summary, in addition to the effects on savings, spending, investment and monetary system, foreign debt has far reaching effects on the financial system. If cash flow available to the countries is interrupted for any reason then some of the LDC’s will find no other way but to default in their debt obligations. Therefore they will be forced to reduce the demand for goods and services causing serious recession. Even if a country does not default in its payments, the interest on debt service is too high to absorb their export earnings. Another effect of debt is the fact that it restricts freedom of action when income decreases and debt servicing needs much of the income which is left.

Some Policy Solutions to the Problem

From 1983, most of the LDC’s are showing a positive response to solve their debt problems. Brazil, Korea, Columbia and Mexico are on the top. Mexico and Brazil were among the countries that had serious problems in their debt paying obligations, but in recent years both countries improved a lot. In Mexico, non-interest budget had improved by more than 7 % of G.N.P. In less than three years but, due to oil price fall of 1986, budget deterioration was 6-7 % of G.N.P. In 1983-85 surpluses were enough to meet the interest payments. Real wages and interest rates were 40 % lower than their 1980 levels.[6].

Brazil improved a lot; its economic growth was 8 % in 1986. Current account balance was in surplus for $ 3 billions in 1986. Export earnings grew at the rate of 8 % during 1984-1987. Debt-export ratio fell down to 300 % by the end of 1987 which is about 1/6 less than their 1983 level. Interest payments now only absorb 20 % of its export earnings.[7] U.S Banks have decreased the ratio of their Latin American exposures to their own primary capital from 125 % in 1982 to 75 % in 1986.[8]

Many of the LDC’s have learned experience from these countries and have started improving their debt situation but still a lot is needed to be done on this issue to avoid the future crisis. Following are some of the policy solutions which can help in reducing the debt problem.

Elimination of Federal Budget Deficits: – Federal budget deficits are the biggest source of the foreign debt. Therefore, if a government really wants to halt the high growth of debt, the first step is to eliminate the budget deficits. This step will keep the domestic savings free for the investment purposes which can further generate foreign exchange to keep the economy out of the “Debt Trap” in the future. This can be done by reduction in spending. Here the question arises that how to distribute the cut in spending between the various components: government, consumption and investment. In this regard the best cut would be the cut in government expenditures on non-productive projects. Because the cut in consumption will indirectly kill the incentives to invest. The cut in investment has a multiplier effect that translates into a reduction in output, income, and hence private spending.

Foreign Exchange Shortages: – The second issue in adjusting to debt regards the fact that the country needs to earn foreign exchange not their own currency. In other words, it needs to generate a trade surplus. In LDC’s much of the foreign debt is used to build non-productive projects. If the same capital is used on productive projects like “export promotion” or “import substitution” investments, the debt burden will be less. Because the new investment will crate or save enough foreign exchange to make the future payment without creating the additional tax burden on the community.

In this regard, the concept of Net Present Value (NPV) should be kept in mind.[9]

If the NPV of the project under study is positive or greater than zero then it is recommended to invest in that project, because that project will generate enough return to pay for the interest and the principle.

Revision of the Tax Policies: – Some of the LDC’s tax policies encourage the loan because it is exempted from tax. Such policies should be eliminated.

Reversal of Capital Flight: – Because of unfavorable investment climates and political instability in some of the LDC’s, there was a capital flight of more than $ 70 billion alone from Latin American Countries.[10] The figure for all LDC’s was much higher. Reversing these capital flights would make it almost possible to pay off the external debt. Positive real stable interest rates will help a lot in this regard.

Need for International Cooperation and Coordination: – Developed countries of the world can play a key role in the developing countries. International banks should change their policies while lending to LDC’s. They should borrow according to their needs and on low interest rates. IMF should help LDC’s in accommodating their balance of payments. IMF plays a good role to assist rich industrial nations of the world but is reluctant to help LDC’s. Developed countries of the world should help LDC’s to make structural reforms in their economies.

LDC’s are trying to control their budget deficits but this will be inadequate unless developed countries lend them additional resources to maintain and expand their exports. There is a need for a new International Organization containing the central banks of all LDC’s for better international cooperation and coordination in addition to achieving and maintaining a favorable world economic environment.

Debt-equity Swaps: – Another solution that is finding a lot of favor in the financial community is the system of debt-equity swaps. In this system an investor of a creditor nation purchases in the second-hand market the debt of debtor nation at a 30 % discount. This debt then is presented to the debtor nation federal bank for redemption at par into their currency units at a premium prevailing in the free market. That amount is then spent on purchasing some assets being liquidated by the public sector. When the accounts are done, the external debt is reduced. It may be an extraordinary expensive way to clean up the balance sheet. But it will promote foreign investment, both direct and portfolio investment.

Conclusion

The rapid growth of LDC’s debt from 1976-1983 caused major problems in the world economic and financial system. Major reasons for this debt crisis were the rise in oil prices in 1973-1974, and 1979-1980, higher interest rates of 1980-1982, and declining exports due to world recession of 1980-1981. Brazil, Korea, Columbia and Mexico are on the top. Mexico and Brazil were among the countries that had serious problems in their debt paying obligations, but in recent years both countries improved a lot. In Mexico, non-interest budget had improved by more than 7 % of G.N.P. in less than three years but, due to oil price fall in 1986, budget deterioration was 6-7% of G.N.P. In 1983-85 surpluses were enough to meet the interest payments. Real wages and interest rates were 40% lower than their 1980 levels.[11] Brazil improved a lot; its economic growth was 8 % in 1986. Current account balance was in surplus for $ 3 billions in 1986. Export earnings grew at the rate of 8 % during 1984-1987. Debt-export ratio fell down to 300% by the end of 1987 which is about 1/6 less than their 1983 level. Interest payments now only absorb 20% of its export earnings.[12] U.S Banks have decreased the ratio of their Latin American exposures to their own primary capital from 125% in 1982 to 75% in 1986.[13]

Many of the LDC’s have learned from these countries and have started improving their debt situation but still a lot is needed to be done in this aspect to avoid the future crisis. Reversing the capital flights would make it almost possible to pay off the external debt. Positive real stable interest rates will also help a lot in this regard. Developed countries of the world can play a key role in the developing countries. International banks should change their policies while lending to LDC’s. They should borrow according to their needs and on low interest rates. IMF should help LDC’s in accommodating their balance of payments. IMF plays a good role to assist rich industrial nations of the world but, is reluctant to help LDC’s. Developed countries of the world should help LDC’s to make structural reforms in their economies.

LDC’s are trying to control their budget deficits but this will be inadequate unless developed countries lend them additional resources to maintain and expand their exports. There is a need for a new International Organization containing the central banks of all LDC’s for better international co-operation and co-ordination to achieve and maintain a favorable world economic environment. Effects of the debt crisis were deep for LDC’s and developed countries both. The biggest fear was the failure of the world financial system due to the high lending to LDC’s, more than their net worth. The crisis started halting by the end of 1982, when most of the LDC’s showed the less dependence on foreign aids and showed a positive response in meeting their debt obligations. The problem is still here yet not so worse.

Footnotes

[1] See, Chinweizu, “Debt Trap Peonage”, Monthly Review, November 1985 for more details.

[2] See, World Development Report-1985, Washington D.C., p-115.

[3] See, World Development Report-1985, p-64.

[4] See, World Development Report-1986 for all the factual information.

[5] Nine largest U.S.’s banks namely, Citicorp, Bank of America, Chase Manhattan, Morgan Guaranty, Manufacturers Hanover, Chemical Bank, Continental Illinois, Bankers Trust, and First National Chicago.

[6] For all factual information about Mexico, see, Dornbusch, Rudiger, “International Debt and Economic Stability”, Economic Review, Jan. 1987, pp.23-24.

[7] For all information about Brazil, see, Vries, Rimmer de., “Commentary on International Debt and Economic Stability”, Economic Review, Jan, 1987, pp. 33-35.

[8] As above.

[9] See, “Malcolm Gillis”, (1983) pp.135

[10] Same as # 2.

[11] For all factual information about Mexico, see “Rudiger Dornbusch”, (1987), pp. 23-24.

[12] For all factual information about Brazil, see “Rimmer De Vries”, (1987), pp. 33-35.

[13] Same as above.

Bibliography

Dornbusch, Rudiger, International Debt and Economic Stability, Economic Review, Jan. 1987.

IMF, World Economic Outlook, (1976, 1979, 1982, 1983, & 1984).

IMF, International Financial Statistics, (1974, 1976, 1979, & 1983).

Gillis, Malcoln, Perkins, Dwight H., Roemer, Michael, and Snodgrass

Donald R., Economics of Development, N.Y., W.W. Norton & Co., (1983).

Kettell, Brian, and Magnus George, The International Debt Game, Massachusetts, Ballinger Publishing Co., (1986).

Vries, Rimmer de., Commentary on International Debt and Economic Stability, Economic Review, Jan.1987.

Watkins, Alfred J., Till Debt Do Us Apart, N.Y., Roosevelt Center for American Policy Studies, (1986).

World Bank, World Development Report, 1975, 1977-1983, 1985-1986 and 1988.