External Debt: Problems and Policies Thorvaldur Gylfason

It depends If foreign borrowing is used well, to finance profitable investments, etc., then borrowing may be a good thing Many countries have developed with the aid of external loans This is how the US built its railways and how Korea managed to develop so rapidly from the 1960s onwards This is how the US built its railways and how Korea managed to develop so rapidly from the 1960s onwards Both countries paid back their debts Both countries paid back their debts External debt: Good or bad?

Many other countries have fared less well with their external debt strategies because they did not use their foreign loans well Too often, countries have borrowed abroad to finance consumption, not investment Consumption does not increase the ability of indebted countries to service their debts, nor does low-quality investment But high-quality investment does External debt: Good or bad?

If the world interest rate is lower than the domestic interest rate, the country will be a borrower in world financial markets Domestic firms will want to borrow at the lower world interest rate Domestic households will reduce their saving because the domestic interest rate moves down to the level of the world interest rate Conceptual framework

Real interest rate 0 Saving, investment Saving Investment World interest rate World equilibrium Domestic saving Domestic investment Domestic equilibrium Borrowing Conceptual framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A B C D Borrowing Conceptual framework Real interest rate Saving, investment

0 Saving Investment World equilibrium Domestic equilibrium A Consumer surplus before borrowing C B Producer surplus before borrowing Real interest rate Saving, investment Conceptual framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A Consumer surplus after borrowing B D C Producer surplus after borrowing Borrowing Conceptual framework Real interest rate Saving, investment

The area D shows the increase in total surplus and represents the gains from borrowing Before tradeAfter tradeChange Consumer surplus AA + B + D+ (B + D) Producer surplus Producer surplusB + C C- B Total surplus Total surplusA + B + CA + B + C + D+ D Conceptual framework

Borrowers are better off and savers are worse off Borrowers are better off and savers are worse off Borrowing raises the economic well- being of the nation as a whole because the gains of borrowers exceed the losses of savers Borrowing raises the economic well- being of the nation as a whole because the gains of borrowers exceed the losses of savers If world interest rate is above domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains If world interest rate is above domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains Gains from trade: Three main conclusions

Debt stock Usually measured in dollars or other international currencies because debt needs to be serviced in foreign currency Debt ratio Ratio of external debt to GDP Ratio of external debt to exports nMore useful for some purposes, because export earnings reflect the ability to service the debt External debt: Key concepts

Debt burden Also called debt service ratio Equals the ratio of amortization and interest payments to exports q = debt service ratio A = amortization r = interest rate D F = foreign debt X = exports

Interest burden Ratio of interest payments to exports q = a + b Amortization burden Also called repayment burden Ratio of amortization to exports External debt: Key concepts

Magnitude of the debt Debt should not become too large How large is too large? Measurement of the debt Gross or net? May subtract foreign reserves in excess of 3 months of imports Composition of the debt FDI, portfolio equity, long-term loans, short-term loans External debt: Magnitude and composition

Composition of the debt Foreign direct investment Least likely to flee, most desirable Portfolio equity Long-term loans Short-term loans Most volatile, least desirable As a rule, outstanding short-term debt should not exceed foreign reserves External debt: Magnitude and composition Indonesia and Korea broke this rule in 1996

How can we figure out a country’s debt burden? Divide through definition of q by income Now we have expressed the debt service ratio in terms of familiar quantities: the interest rate r, the debt ratio D F /Y, and the export ratio X/Y as well as the repayment ratio A/Y External debt: Numbers

Suppose that r = 0.06 D F /Y = 0.50 A/Y = 0.05 X/Y = 0.20 Here we have a country that has to use 40% of its export earnings to service its external debt Heavy burden! Numerical example

African countries: External debt 1999 (% of exports) Ceiling

African countries: External debt 1999 (% of GDP) Ceiling

African countries: External debt service 1999 (% of exports) Ceiling

African countries: Exports 1999 (% of GDP) Average

African countries: Current account balance 1999 (% of GDP) Average

African countries: Gross foreign reserves 1999 (months of imports) Ceiling

African countries: Short-term debt 1999 (% of foreign reserves) Ceiling

Debt accumulation is, by its nature, a dynamic phenomenon A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on Debt accumulation can develop into a vicious circle How do we know whether a given debt strategy will spin out of control or not? How do we know whether a given debt strategy will spin out of control or not? To answer this, we need a little arithmetic External debt dynamics

Recall balance of payments equation: BOP = X – Z + F where F = capital inflow =  D F where D F = foreign debt Capital inflow, F, thus involves an increase in the stock of foreign debt, D F, or a decrease in the stock of foreign claims (assets) So, F is a flow and D F is a stock External debt dynamics

Now assume Z = Z N + rD F Z = total imports Z N = non-interest imports rD F = interest payments Further, assume X = Z N BOP = 0 A flexible exchange rate maintains equilibrium in the balance of payments at all times Then, it follows that BOP = X – Z +  D F = 0 so that  D F = rD F  D F = rD F In other words: External debt dynamics

So, now we have: Now subtract growth rate of output from both sides: External debt dynamics

But what is This is proportional change in debt ratio: ? This is an application of a simple rule of arithmetic: %  (x/y) = %  x - %  y External debt dynamics

z = x/y log(z) = log(x) – log(y)  log(z) =  log(x) -  log(y) But what is  log(z) ? So, we obtain Q.E.D. Proof

We have shown that where Debt ratio Time  r  g r = g r  g Need economic growth to keep the debt ratio under control Debt, interest, and growth

It is important to keep economic growth at home above – or at least not far below – the world rate of interest Otherwise, the debt ratio keeps rising over time External deficits can be OK, even over long periods, as long as external debt does not increase faster than output and the debt burden is manageable to begin with A rising debt ratio may also be OK as long as the borrowed funds are used efficiently Once again, high-quality investment is key What can we learn from this?

Let us now study the interaction between trade deficits, debt, and growth Two simplifying assumptions:  D t = aY t (omit the superscript F, so D = D F ) Trade deficit is constant fraction a of output Y t = Y 0 e gt Output grows at constant rate g per year Y t Exponential growth Debt dynamics: Another look

Y time Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate log(Y) time 1 g Pictures of growth

at time T Debt as the sum of past deficits

at time T Debt as the sum of past deficits

Evaluate this integral between 0 and T at time T Debt as the sum of past deficits

Evaluate this integral between 0 and T So, as T goes to infinity, D t becomes infinitely large. But that may be quite OK in a growing economy! at time T Debt as the sum of past deficits

So, as T goes to infinity, D T /Y T approaches the ratio a/g Debt as the sum of past deficits

Suppose Trade deficit is 6% of GNP a = 0.06 Growth rate is 2% per year g = 0.02 Then the debt ratio approaches d = a/g = 0.06/0.02 = 3 This point will be reached regardless of the initial position as long as a and g remain unchanged Debt ratio Time 3 Numericalexample

Must adjust policies Must either Reduce trade deficit by stimulating exports or by reducing imports, or Increase economic growth Otherwise, the debt ratio will reach unmanageable levels, automatically No country can afford an external debt equivalent to three times annual output What to conclude?

Because the debt burden then becomes unbearable Recall our earlier numerical example where we looked at the relationship between the debt ratio and the debt burden Korea is a case in point Its export-oriented growth strategy reduced the numerator and increased the denominator of the debt ratio, thereby quickly reducing the country’s debt burden An import-substitution strategy would reduce both numerator and denominator with an ambiguous effect on the debt burden And why not?

Suppose that r = 0.06 (as before) D/Y = 3 D/Y = 3 (our new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Here we have a country whose entire export earnings do not suffice to service its debts Heavy burden, indeed! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 2 D/Y = 2 (our new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Heavy burden, still! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 1 D/Y = 1 (new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Heavy burden, still! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 0.4 D/Y = 0.4 (new number) A/Y = 0.05 (as before) X/Y = 0.20 (as before) Heavy burden, still! Numerical example, again

Suppose that r = 0.06 (as before) D/Y = 0.4 D/Y = 0.4 (as before) A/Y = 0.05 (as before) X/Y = 0.30 (new number) Heavy burden, but manageable! Numerical example, again

African countries: External debt 1999 (% of GDP) Recap

African countries: External debt service 1999 (% of exports) Recap

Borrowers often renegotiate the terms of their loans in mid-stream in order to delay repayments, that is, extend the maturity of the loans, or to delay repayments, that is, extend the maturity of the loans, or to reduce interest payments by replacing high- interest loans by loans with lower interest reduce interest payments by replacing high- interest loans by loans with lower interest Sometimes, outright debt forgiveness may be called for But debt forgiveness is no substitute for sound economic policies Remember: our formula d = a/g holds in the long run regardless of initial conditions Debt renegotiations and forgiveness

External borrowing is a necessary and natural part of economic development This requires countries that borrow to invest the funds borrowed in high-quality capital This is necessary to be able to service the debt If debt burden becomes too heavy, must either reduce deficit or spur growth It is always desirable anyway to do everything possible to encourage economic growth Rapid growth allows more foreign borrowing without making the debt burden unmanageable In conclusion