Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 13 Balance of Payments, Developing-Country Debt, and the Macroeconomic Stabilization Controversy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Balance of Payments The current account: net flow of merchandise trade The capital account: net flow of financial capital

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Balance of Payments The current account: Exports (+) Imports (-) Investment income (+) Debt-service payments (-) Net remittances and transfers (+)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Balance of Payments The capital account: Direct private investment (+) Foreign loans (+) Foreign assets of domestic banks (-) Resident capital outflow (-)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-5

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13-6

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Balance of Payments The balance of payments position: – Surplus: inflows > outflows – Deficit: outflows > inflows Consequence: – Surplus: increase in cash reserves account – Deficit: decrease in cash reserves account

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Payments Balances on Current Account, 1980–2006 (billions of dollars)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Consequences of BOP Deficit Reduce cash reserves account Inhabit imports: impose tariffs/quotas; foreign exchange devaluation Increase exports: foreign exchange devaluation

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Consequences of BOP Deficit Impose restrictive fiscal and monetary policy – Reduce income expansion to lower import growth – Reduce inflation for exports to compete internationally Attract direct foreign investment Receive a greater share of the IMF’s “paper gold” known as the Special Drawing Rights (SDRs) Increase external debt

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Third World Debt Crisis The accumulation of external debt Since early 1980s Allocation of a larger percentage of the GDP (from export earnings) to service external debt Scarcity of development funds: lack of investment in physical, human, and social capital

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Dimensions of the LDC Debt Burden, 1970–2008

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Severely Indebted Countries Large outstanding debt Debt as a large percentage of GDP and exports High debt service-to-GDP (or GNI) ratio High debt service-to-exports ratio

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Copyright © 2009 Pearson Addison-Wesley. All rights reserved External Debt Accumulation Define F n as the capital inflow (i.e., the amount of debt accumulation) F n = dD D = total external debt d = percentage increase in total external debt

Copyright © 2009 Pearson Addison-Wesley. All rights reserved External Debt Accumulation Define BT as the basic transfer and r as average interest rate charged on external debt BT = dD – rD = (d - r)D - dD: external debt - rD: amortized debt - d>r: debt accumulation

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Debt Crisis Rising d and d > r Switching from fixed, concessional rates to short-term, variable rates BOP deficits as LDCs’ commodity prices plummeted

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Debt Crisis Global recession, reducing demand for LDC exports Lack of confidence in LDCs’ ability to repay foreign loans Substantial amount of capital flight from the LDCs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Petrodollars and Third World Debt The OPEC (i.e., Qatar, Saudi Arabia, Kuwait): Exports oil to LDCs and MDCs Deposits some of their export earnings in Western banks Provides grants and interest-free loans to LDCs Western Banks: Lend petrodollars to LDCs Receive debt service payments from LDCs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Mechanics of Petrodollar Recycling

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The IMF Stabilization Policy Remove foreign exchange and import controls Use a floating foreign exchange rate Adopt stringent anti-inflationary policy – Increase interest rates – Reduce budget deficits – Control wage increases – Eliminate price subsidies Invite foreign investment and improve economic openness

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The IMF Stabilization Policy Success in LDCs: Reduce inflation Improve balance of payments Eliminate parallel exchange rates Improve economic efficiency

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The IMF Stabilization Policy Failure in LDCs: Double standards – Harsh adjustments for the LDCs – No adjustment for the MDCs Lending agencies – Agents of international capitalism – Increase LDC dependence and poverty – Prefer short-term to long-term developmental loans – Provide funds for corrupt LDC governments

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Global Dimensions of LDC Debt Restructuring of short-term to long-term loans Debt forgiveness to selected LDCs if they continue to use IMF stabilization policy Debt-for-equity swap: banks exchange loans for ownership of domestic industries Debt-for-nature swap: MDC government forgive loans if LDCs invest in preserving the environment

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Has the Debt Crisis Disappeared? No! Debt crisis is just postponed! LDCs continue to borrow LDCs continue to make large debt service payments In addition to the severely indebted LDCs, countries in Africa are greatly dependent on external debt