Development Economics - Foreign sources of finance and foreign debt
In this chapter we will study foreign direct investment (FDI), foreign aid, multilateral assistance, and the debt problem of developing countries.
Terms in this set (129)
The functions of foreign sources of finance - summary
1. Helping countries acquire foreign exchange
2. Adding to insufficient domestic savings
3. Adding to technical skills, management skills and technology
The functions of foreign sources of finance - Helping countries acquire foreign exchange
Foreign sources of finance create credits in the balance of payments. Therefore, if there is a deficit in the current account, which is likely to be due to a trade deficit, these inflows lead to a supply of foreign exchange (credits) used to pay for this deficit.
The functions of foreign sources of finance - Adding to insufficient domestic savings
Developing countries, because of their relatively low incomes, often have a low amount of savings, leading to low levels of investment. Foreign sources of finance can be used in addition to domestic savings to help countries increase investments in numerous areas that support growth and development.
The functions of foreign sources of finance - Adding to technical skills, management skills and technology
Developing countries often have low levels of skills and technology. Some foreign sources of finance can help countries develop their skills and technology levels, which are a big push in favour of growth and development.
Describe the nature of foreign direct investment (FDI) and multinational corporations (MNCs)
Foreign direct investment (FDI) is investment by firms based in one country (the home country) in productive activities in another country (the host country). A firm that undertakes foreign direct investment is referred to as a multinational corporation (MNC), because it operates in more than one country. A 'corporation' is a type of firm composed of a legal entity that is separate from the individuals who own it.
Introducing multinational corporations
Multinational corporations run business operations in both the home country and in other (host) countries. Historically, MNCs have been active since about the middle of the 19th century. Their importance grew in the 1950s when US multinationals stepped up their investments in Europe as part of European postwar reconstruction.
Multinational corporations have their headquarters mostly in developed countries, dominated by the European Union, Japan and the United States. However, developing and transition countries are rapidly increasing their share in global foreign direct investments.
The scope and growth of multinational corporations
The world of multinational corporations is vast and growing very rapidly. By 2009 MNC's employed 80 million people in their foreign affiliates alone. They amounted to 11% of global GDP and the value of their exports was 33% of global exports.
Yet foreign direct investment remains a small share
of total private investment in developing countries;
total investment by local firms tends to be far greater than total investment by multinational corporations. This raises an interesting question. If foreign direct investment forms only a small share of total private investment in developing countries, why is it the subject of heated discussions and controversy?
The answer is that foreign direct investment is qualitatively very different from local investment. It differs because of the very large size of MNCs, their significant economic and political power, and their superior technical and managerial expertise, know-how and technologies.
Foreign direct investment is by far the most important source of foreign finance flows to developing countries. However, for many low-income developing countries that are almost completely bypassed by MNCs, foreign aid is the main source of foreign finance.
Explain the reasons why MNCs expand into economically less developed countries - summary
Multinational corporations expand into developing countries (as elsewhere) in the hope of securing higher profits. Developing countries offer possibilities for MNCs to:
1. increase sales and revenues
2. bypass trade barriers
3. lower costs of production
4. use locally produced raw materials
5. further their activities in natural resource extraction
Explain the reasons why MNCs expand into economically less developed countries - increase sales and revenues
Some developing countries have large or rapidly growing markets (for example, China, India and countries in Latin America), which offer the potential for large increases in sales and revenues. If the firm is located within the country, it can more easily capture a market share, as well as speed up delivery of products and save on transportation costs.
Explain the reasons why MNCs expand into economically less developed countries - bypass trade barriers
Producing in countries with trade barriers allows MNCs to bypass these and secure access to local markets.
Explain the reasons why MNCs expand into economically less developed countries - lower costs of production
Labour costs as a rule take up a large proportion of total production costs, and developing countries generally have lower labour costs than in developed countries. This is a key reason for example, why the United States has multinational corporations operating in Mexico.
Explain the reasons why MNCs expand into economically less developed countries - use locally produced raw materials
If an MNC needs raw materials in the form of natural resources for its production, it is far less costly to obtain them locally than to import them, on account of transportation costs.
Explain the reasons why MNCs expand into economically less developed countries - further their activities in natural resource extraction
Some MNCs specialise in the extraction of natural resources (oil, aluminium, bauxite, etc.). Many developing countries are very rich in natural resources (for example in Africa), and therefore it is natural for MNCs to want to locate in such resource-rich countries.
Describe the characteristics of economically less developed countries that attract FDI - summary
1. Geographical distribution of foreign direct investment
2. Attractive characteristics of developing countries
Describe the characteristics of economically less developed countries that attract FDI - Geographical distribution of foreign direct investment
In 2009, the share of developing country inflows was over 46% of global inflows.
Foreign direct investment in developing countries is not evenly distributed throughout geographical regions. In 2009, East Asia (mainly China) and Latin America and the Caribbean had the largest shares of FDI inflows, while Sub- Saharan Africa was lagging far behind.
Describe the characteristics of economically less developed countries that attract FDI - Attractive characteristics of developing countries
The above pattern suggests that multinational corporations are highly selective in their choice of hosts, preferring to invest in countries that display certain characteristics. Aside from seeking host countries that provide low-cost labour and natural resources, they are attracted to countries offering an economic and political environment that is most likely to ensure profitability and safety. The most important of these characteristics include the following:
1. political stability and political institutions that ensure a stable political environment
2. a stable macroeconomic environment (low inflation, stable currency, acceptable levels of foreign debt, absence of major balance of payments problems)
3. an institutional environment that favours foreign direct investment, such as
- freedom to repatriate profits (i.e. send profits to the home country)
- freedom to engage in foreign exchange transactions (no exchange controls, thus can import possible needed inputs without restrictions; see page 495)
- favourable tax rules (to ensure low tax payments)
lack of restrictions regarding foreign ownership
- well-established property rights
- rules that minimise the risk of nationalisation (a takeover of private property by the state)
4. a liberalised (free market) economy with limited government intervention (including privatisation of state-owned enterprises)
5. liberal (free market) trade policy with an emphasis on exports
6. large markets
7. rapid economic growth and expectations of
continued rapid growth
8. well-functioning infrastructure, including transportation and communications, that will facilitate imports and exports
9. a well-educated labour force
What attractive characteristics of developing countries mean for MNC's
The characteristics required of host countries are those that provide MNCs with the freedom to pursue their economic interests with the least amount of government interference, in a safe economic and political environment that minimises uncertainties and potential risks of losses on their investments. Recipients of the largest amounts of foreign direct investment are countries that best satisfy these conditions, and are mostly concentrated in the middle-income groups (upper middle and lower middle) of developing countries.
In view of the requirements of MNCs, it is easy to see that the rapid growth of foreign direct investment around the world in the past two to three decades has been driven by the liberalisation of the global economy and the domestic economies of many countries. Since the 1980s, as developing countries turned more and more toward the market as the basis for policy, so MNCs have found it profitable to establish affiliates in hospitable foreign countries that accommodate their needs.
Evaluate the impact of foreign direct investment (FDI) for economically less developed countries - summary
1. Potential advantages of MNCs for host developing countries
2. Potential disadvantages of MNCs for host developing countries
Potential advantages of MNCs for host developing countries - summary
1. MNCs can supplement insufficient foreign exchange earnings
2. MNCs can supplement and improve upon local technical skills, management skills and technology
3. MNCs can supplement insufficient domestic savings and increase investment and new capital formation
4. MNCs can lead to greater tax revenues in the host country
5. MNCs can help promote local industry
6. MNCs can increase local employment and help lower unemployment in the host country
7. MNCs can lead to higher economic growth in the host country
Potential advantages of MNCs for host developing countries - MNCs can supplement insufficient foreign exchange earnings
Investment funds flowing into a country from abroad appear as credits in the financial account, and can help offset a current account deficit. As the activities of multinational corporations are usually export oriented, the country's exports are expected to increase, resulting in increased export earnings and positive effects on the country's balance of payments position.
Potential advantages of MNCs for host developing countries - MNCs can supplement and improve upon local technical skills, management skills and technology
When multinational corporations set up affiliates in developing countries, they bring with them technical and managerial expertise, as well as new production technologies, which can be learned and adopted by the local labour force (workers and managers) and local businesses. This involves technological improvements as well as improvements in human capital (the acquisition of new skills and knowledge by the local labour force), and is considered to be one of the important advantages of foreign direct investment for developing countries.
Potential advantages of MNCs for host developing countries - MNCs can supplement insufficient domestic savings and increase investment and new capital formation
The inflows of FDI funds into a country can supplement insufficient domestic savings, increasing the amount of investment.
Potential advantages of MNCs for host developing countries - MNCs can lead to greater tax revenues in the host country
If multinational corporations are taxed by the government of the host country, this will contribute to increased tax revenues.
Potential advantages of MNCs for host developing countries - MNCs can help promote local industry
When MNCs buy locally produced goods and services as inputs into their production, they promote the development of local industries. This may lead to the growth of existing local firms, or the establishment of new local firms to provide inputs to the MNC.
Potential advantages of MNCs for host developing countries - MNCs can increase local employment and help lower unemployment in the host country
By establishing productive facilities (investing) in the host country, MNCs can increase employment by hiring local workers. In addition, the promotion of local industry also contributes to increasing domestic employment.
Potential advantages of MNCs for host developing countries - MNCs can lead to higher economic growth in the host country
Increased levels of investment, improved technology and increases in human capital as well as the promotion of local industry and greater tax revenues, can lead to higher economic growth in the host country with increased possibilities for pursuing development objectives.
Potential disadvantages of MNCs for host developing countries - summary
1. Why the benefits listed above might not come about
2. Further possible negative effects of MNCs
Potential disadvantages of MNCs for host developing countries - Why the benefits listed above might not come about - summary
1. MNCs may not always supplement insufficient foreign exchange earnings
2. MNCs may not improve on local technical skills, management skills and technology
3. MNCs may not lead to greater tax revenues in the host country
4. MNCs may not help promote local industry
5. MNCs may not help lower unemployment in the host country
Potential disadvantages of MNCs for host developing countries - Why the benefits listed above might not come about - MNCs may not always supplement insufficient foreign exchange earnings
MNCs usually do bring foreign exchange into the host country. However, MNCs also engage in activities that result in foreign exchange outflows. These outflows may occur because of repatriation of profits (profits sent back to the host country); or because MNCs import raw materials and other inputs for use in production; or because they finance their activities by borrowing from the parent corporation in the home country, in which case they must repay the loan plus pay interest. The result is that the net inflows of foreign exchange (inflows minus outflows) may be small.
Potential disadvantages of MNCs for host developing countries - Why the benefits listed above might not come about - MNCs may not improve on local technical skills, management skills and technology
Critics argue that MNCs' influence on the development of local skills may be very small, as in practice the links between MNC activities and the local economy are often limited, in which case local workers do not have the opportunity to learn from the MNC. Also, MNCs often hire personnel from the home country, thus limiting learning opportunities for the local labour force.
Potential disadvantages of MNCs for host developing countries - Why the benefits listed above might not come about - MNCs may not lead to greater tax revenues in the host country
While MNCs are taxed by host country governments, they enjoy many tax privileges and benefits, often lowering the amount of tax paid. Tax benefits are offered as an incentive to attract MNCs into the host country. Another reason why MNCs pay less tax involves the practice of transfer pricing, which allows MNCs to lower their stated profits. Transfer pricing works in the following way. Many MNCs buy and sell inputs and intermediate products from their various affiliates in other countries. By claiming to local tax authorities that the prices they have paid for the purchase of inputs from their affiliates abroad is higher than the actual price paid, their profits appear lower than true profits. Since the amount of tax paid is a percentage of profit, lower-stated profits mean lower taxes (sometimes significantly lower). It is estimated that lost tax revenues due to transfer pricing are in the billions of dollars each year.
Potential disadvantages of MNCs for host developing countries - Why the benefits listed above might not come about - MNCs may not help promote local industry
The operation of MNCs sometimes forces local competing firms to go out of business, or alternatively does not permit new local firms to establish themselves in industries that are directly competitive with the MNC.
Potential disadvantages of MNCs for host developing countries - Why the benefits listed above might not come about - MNCs may not help lower unemployment in the host country
If, as noted above, MNCs prevent the development of local industry, then their job-creating impact will be limited. In addition, some MNCs may sometimes import into the host country capital-intensive technologies that are inappropriate to local conditions given large labour supplies, thus contributing to unemployment and underemployment, and the growth of the urban informal sector. (However, some MNCs engage in labour-intensive activities that make extensive use of cheap local labour).
Potential disadvantages of MNCs for host developing countries - Further possible negative effects of MNCs - summary
1. MNCs and environmental degradation
2. MNCs promote inappropriate consumption patterns in developing countries
3. MNCs may use government resources to build infrastructure needed by MNCs rather than for poverty alleviation
4. MNCs may use their economic and political power to bring about policies that may work against economic development
5. Competition between developing countries to host MNCs and the 'race to the bottom'
Potential disadvantages of MNCs for host developing countries - Further possible negative effects of MNCs - MNCs and environmental degradation
MNCs often pursue activities that cause serious environmental degradation. They prefer to invest in countries that impose few environmental restrictions, and they have been known to engage in activities that have caused tremendous environmental damage. Moreover, MNCs are responsible for the production of the bulk of industrial pollutants (such as chlorofluorocarbons, a main cause of ozone depletion, as well as pesticides, plastics, petroleum, industrial chemicals, and many others). It has been estimated that about 80% of greenhouse gas emissions are caused by substances produced by MNCs.
Potential disadvantages of MNCs for host developing countries - Further possible negative effects of MNCs - MNCs promote inappropriate consumption patterns in developing countries
Critics charge that MNCs, through advertising, create new consumption needs and promote inappropriate consumption patterns. This charge applies to the role of MNCs in developed countries as well, but what makes it more powerful in the case of developing countries is that populations plagued by hunger, malnutrition, disease and lack of basic services can less afford to spend their small incomes on unnecessary goods while their basic needs remain unsatisfied. Examples include consumption of soft drinks, sweets, fast foods, white bread, expensive brand name goods, and many others.
Potential disadvantages of MNCs for host developing countries - Further possible negative effects of MNCs - MNCs may use government resources to build infrastructure needed by MNCs rather than for poverty alleviation
MNCs sometimes require infrastructure (road systems, ports, telecommunications, etc.) which the developing country must make available if it is to become attractive as a host country. To build these types of infrastructure, it may have to shift some of its scarce resources away from needed merit goods (clean water, sanitation, schools and health care services) and toward infrastructure for MNCs.
Potential disadvantages of MNCs for host developing countries - Further possible negative effects of MNCs - MNCs may use their economic and political power to bring about policies that may work against economic development
The very large size of many MNCs gives them exceptional economic and political power that they can use to influence host governments to pursue policies that are in their own interests but against economic development. For example, MNCs are interested in investing in countries that have weak labour protection laws, because little or no labour protection results in lower costs of production; and they are interested in investing in countries with weak environmental regulations, as this allows them to avoid costs associated with environmental protection. When the interests of MNCs and those of developing countries conflict, developing country governments find themselves in a weak bargaining position because if they do not give in to MNC demands, they will lose the investment to another developing country that is more willing to compromise.
For example, in Thailand and Peru, MNCs threatened to relocate to other countries if environmental regulations were enforced. In Peru, a mining company pressured
the government not to undertake health tests for children living close to the mining operations.
Potential disadvantages of MNCs for host developing countries - Further possible negative effects of MNCs - Competition between developing countries to host MNCs and the 'race to the bottom'
Many developing countries compete with each other over which will create better conditions to attract MNCs. Yet MNC demands may conflict with what is in a country's best interests. This has been termed 'the race to the bottom', because the desire to host MNCs may involve sacrifices of needed development, lowering government tax revenues, and use of local resources for infrastructure instead of merit good provision. Additional sacrifices may involve too much economic and trade liberalisation.
Definition of foreign aid
Foreign aid is defined as the transfer of funds or goods and services to developing countries with the main objective to bring about improvements in their economic, social or political conditions.
What are the conditions for something to be foreign aid?
1. They must be concessional, which means that the transfers involve more favourable conditions than could be achieved in the market. In other words, when the aid involves loans, interest rates are lower and repayment periods are longer than borrowers would get in the commercial banking system. Also, the aid may involve grants, which are gifts of either money or goods and services that do not need to be repaid.
2. They must be non-commercial, meaning that they must not involve buying and selling (commerce) or other activities concerned with making a profit.
Who offers aid?
There are two sources of aid. The first is Official Development Assistance (ODA), provided by developed country governments, and the second is aid provided by non-governmental organisations (NGOs).
What are the two main categories of aid?
There are two main categories of aid: humanitarian and development.
Humanitarian aid and development aid are offered by both ODA and NGOs. Whatever the kind of aid, whenever it involves financial inflows, these enter as credits in the balance of payments, thus bringing in foreign exchange and helping countries offset possible deficits in their trade balance.
Definition of humanitarian aid
Humanitarian aid involves aid extended in regions where there are emergencies caused by violent conflicts or natural disasters such as floods, earthquakes and tsunamis. They are intended to save lives, to ensure access to basic necessities such as food, water, shelter and health care, and to provide assistance with reconstruction work in order to help displaced people cope.
Humanitarian aid is extended by donors through grants (sending money as a gift) or through goods-in-kind (food, medical supplies, blankets, etc.).
Definition of development aid
Development aid is intended to help developing countries achieve their economic growth and development objectives. It may take the following forms:
1. Project aid involves financial support for specific projects, such as building schools, clinics, hospitals, irrigation systems or other agricultural infrastructure.
2. Programme aid involves financial support to sectors, such as education, health care, agriculture, urban development, the financial sector (credit, banking, insurance), energy, the environment, or others.
3. Technical assistance involves the provision of technical advice by developed country specialists such as doctors, teachers, agronomists, etc. Technical assistance may sometimes be part of project aid or programme aid.
4. Debt relief. Very poor countries with high levels of foreign debt sometimes receive aid involving some debt forgiveness.
Development aid is extended by donors through grants or through concessional long-term loans as well as debt forgiveness.
Definition of Official Development Assistance (ODA)
Official Development Assistance (ODA), all of which is public in the sense that it comes from government funds, forms the largest part of foreign aid. Most ODA funds (nearly three-quarters) take the form of grants.
How does ODA reach developing countries?
1. through bilateral aid, which is the most important way - funds go directly from the donor government to the developing country recipient; examples of bilateral aid agencies are USAID (US Agency for Internal Development) in the United States and DFID (Department for International Development) in the United Kingdom
2. through multilateral aid, going indirectly from donor governments to international organisations, which transfer the funds to developing country governments
3. through NGOs - donor governments transfer ODA funds to NGOs which spend them in developing countries.
Donor motives for providing ODA - summary
1. Political and strategic motives
2. Economic motives
3. Humanitarian and moral motives
Donor motives for providing ODA - Political and strategic motives
Historically and to the present, political and strategic motives have played a strong role in motivating donor countries to provide aid. During the Cold War, the United States provided aid to restrict the spread of communism. The Soviet Union provided aid to communist states as well as some non-communist states with communist leanings. European powers provided aid to their former colonies. Often aid has been used to support regimes in developing countries that are considered to be 'friendly' to the interests of the donor governments.
Donor motives for providing ODA - Economic motives
Economic motives of donor countries, historically and to the present, have also played a significant role in prompting donor provision of aid. Developed countries often regard it to be in their interest to assist countries with which they have strong economic ties. For example, much of Japan's aid is directed towards neighbouring countries with which it has strong trade and investment links. The practice of tied aid (to be discussed below), is an important example of economic motives of donors. Tied aid forces the recipients of aid to spend a portion of aid funds to buy goods and services from the donor country, thus providing significant economic benefits to donor countries.
Donor motives for providing ODA - Humanitarian and moral motives
Some aid is provided on humanitarian grounds for short- term emergency assistance, such as in the case of famines, wars or natural disasters. Concern about the extent of poverty in developing countries is a motive for allocating aid funds for long-term development purposes. The Millennium Development Goals (MDGs) adopted in 2000 were a global commitment to the alleviation of extreme poverty, hunger, malnutrition, disease, premature deaths and environmental damage, and aid funds are often linked with achieving these goals.
The distribution of ODA around the world
The evidence on the distribution of ODA funds across countries suggests that all these motives play a role in the thinking of donors. Low-income countries receive more ODA per capita than lower middle and upper middle income countries. Similarly, sub-Saharan Africa, with its relatively low GNI per capita also receives a large amount of ODA per capita.
However, there are major exceptions from the pattern where countries with lower GNI per capita receive more ODA per capita. For example, upper middle income countries receive the same ODA per capita as lower middle income countries, though they have GNI per capita levels more than two and a half times greater than the latter. They also receive about one-fourth the ODA per capita of lower income countries, though their GNI per capita is about eight times greater.
The Middle East and North Africa, with GNI per capita about three times greater than in South Asia, receive eight times the amount of aid per capita
Definition of tied aid
Tied aid refers to the practice where donors make the recipients of aid spend a portion of borrowed funds to buy goods and services from the donor country. It occurs only in the context of bilateral (not multilateral) aid, and gives rise to several serious disadvantages.
Explain the disadvantages of tied aid
1. Recipient countries cannot seek lower price alternatives for the goods and services they are forced to buy from the donor country. It has been estimated that tied aid reduces the value of aid by 11-30%, and in the case of tied food aid the costs to the recipient country are as much as 40% higher than in the market.10 This means that recipients of tied aid face much higher than necessary import costs.
2. Having to buy specific goods and services from the donor country often results in buying inappropriate, capital-intensive technologies.
3. Those who benefit from tied aid are usually large firms in developed countries whose goods and services the recipient countries are forced to buy. This is a kind of support for industry of developed countries, occurring at the expense of poor country development objectives.
Approximately one-third to one-half of bilateral aid is tied aid.
Definition of Non-governmental organisations (NGOs)
Non-governmental organisations (NGOs) are the second type of aid flowing into developing countries. Like ODA, they involve concessional flows, but they are all grants (there are no loans that must be repaid).
The World Bank defines NGOs as 'private organizations that pursue activities to relieve suffering, promote the interests of the poor, protect the environment, provide basic social services, or undertake community development.'
NGOs are 'private' in the sense that they are not part of any governmental structure; they are not private in the sense of being part of the market system. NGOs are an expression of civil society, and as such are often referred to as comprising a third sector (the first and second being the government and market sectors).
Explain that, for the most part, the priority of NGOs is to provide aid on a small scale to achieve development objectives
NGOs include a wide variety of organisations, such as charitable organisations, non-profit organisations, nationally based groups with a national or international reach, locally based community groups, or grassroots organisations, and they may operate in developed or developing countries (or both).
NGOs in developing countries have grown massively in numbers and in involvement since the 1980s. Most of these are small local groups pursuing development objectives within a relatively small community.
NGOs obtain their funds from private voluntary contributions including private sector corporations and, increasingly, from bilateral and multilateral ODA funds. In other words, more and more of ODA funds are channelled through NGOs, particularly in the case of humanitarian assistance. The reason for this is that NGOs can perform functions that are not performed as effectively by national governments.
What activities are NGOs involved in?
NGOs are involved in a vast range of activities, including provision of humanitarian aid in times of crisis, promotion of sustainable development, promotion of community development, service delivery, poverty alleviation, protection of child health, promotion of women's rights, promotion of small-scale entrepreneurs, support of the poor in the informal sector, provision of technical assistance to small farmers, provision of credit to poor people (micro-credit schemes), research activities, political advocacy, support for people's movements, and more.
Arguments in favour of Official Development Assistance (ODA) - summary
1. Aid and the poverty cycle
2. Aid and provision of basic services
3. Aid and improved income distribution
4. Aid and economic growth
5. Aid and the Millennium Development Goals (MDGs)
6. Aid, the debt trap and debt relief
Arguments in favour of Official Development Assistance (ODA) - Aid and the poverty cycle
Very poor societies trapped in the poverty cycle face a savings-investment constraint due to very low incomes.
To emerge from a poverty cycle, poor people and poor communities need the government to intervene by undertaking the necessary investments in physical, human and natural capital. However, if the government does not have enough tax revenues, the only way the country, or community within a country, can escape the poverty cycle is through foreign aid that makes up for the lack of savings.
Low-income countries do not have enough funds to provide universal primary education, as well as basic infrastructure services. To be able to finance these services themselves, poor countries would need to achieve economic growth that would provide them with increased economic resources that can be used to invest in health, education and infrastructure.
However, economic growth is not possible unless there is first some investment in these areas. Therefore, these countries are caught in a poverty cycle from which they can escape only if foreign aid provides the financing for these investments.
Arguments in favour of Official Development Assistance (ODA) - Aid and provision of basic services
Even if a country is not caught in a poverty cycle,
aid can make resources available for investments in health, education and infrastructure, which can help poor people improve their employment opportunities and improve their incomes. In a number of Sub- Saharan African countries, foreign aid is an important component of social budgets; in Tanzania, it accounts for more than one-third of social spending.
Many of these programmes contribute to significantly limiting the incidence of preventable diseases and reducing infant and child deaths.
Arguments in favour of Official Development Assistance (ODA) - Aid and improved income distribution
By focusing on the most disadvantaged groups in society, aid can help improve the relative income positions of the beneficiaries and contribute to improved income distribution. Highly unequal income distribution can be a barrier to growth and development.
Arguments in favour of Official Development Assistance (ODA) - Aid and economic growth
There is strong evidence that aid leads to economic growth, because it makes possible increased investment and consumption levels, leading to increased volumes of output. Evidence cited by the UNDP indicates that countries in Sub-Saharan Africa that rely heavily on aid (Mozambique, Tanzania and Uganda) have achieved high growth rates.
Arguments in favour of Official Development Assistance (ODA) - Aid and the Millennium Development Goals (MDGs)
The provision of aid is crucially important to the achievement of the Millennium Development Goals (MDGs). Much of the aid is closely linked to the achievement of these goals. According to the United Nations Development Programme, it will not be possible for developing countries to achieve the MDGs without enough aid.
Arguments in favour of Official Development Assistance (ODA) - Aid, the debt trap and debt relief
Countries that are heavily indebted (have high levels of debt) face serious negative consequences for their growth and development, especially when caught in a 'debt trap', where they must go on borrowing more and more in order to service old debts. Aid for debt relief helps countries reduce their debt burden and releases resources that can be used for poverty reduction and economic growth and development.
Factors that limit the effectiveness of Official Development Assistance (ODA) - summary
A number of factors limit the effectiveness of aid as a mechanism for achieving economic and human development and poverty alleviation. The most important of these include the following.
1. Tied aid
2. Conditional aid (conditionality)
3. Aid volatility and unpredictability
4. Unco-ordinated donors
5. Aid may substitute for rather than supplement domestic resources
6. Aid may not reach those most in need
7. Aid may be associated with corruption
8. The quantity of aid and poverty alleviation
Factors that limit the effectiveness of Official Development Assistance (ODA) - Tied aid
One of the most important limitations of the effectiveness of ODA funds is the practice of tied aid, whose disadvantages for developing countries were explained above.
Factors that limit the effectiveness of Official Development Assistance (ODA) - Conditional aid (conditionality)
Most donors of ODA impose numerous conditions that must be met by the recipients of aid. Donors see these conditions as a mechanism for forcing developing countries to make important policy changes, as well as for ensuring that aid funds are used effectively.
The kinds of conditions that are imposed vary from requiring the recipient to pursue policies intended to achieve a greater market orientation in the economy (such as privatisation, elimination of protective trade barriers, greater reliance on the price mechanism, etc.), to forcing the recipient to accept particular projects that have been decided upon by the donors.
Conditional lending has been found to create disadvantages for developing countries. Donors do not pay sufficient attention to the preferences of the government or of the population groups the project is intended to benefit. Policy prescriptions by donors may be incorrect; they may not fit in with the government's development strategy and priorities; and they may weaken the recipient government's authority and accountability to its citizens.
Factors that limit the effectiveness of Official Development Assistance (ODA) - Aid volatility and unpredictability
The flow of aid funds (particularly bilateral flows)
into developing countries is volatile (unstable) and unpredictable. This is partly due to changing volumes of aid in donor budgets, and changing donor priorities on how to allocate aid funds. This makes it difficult for recipient governments to implement policies that depend on aid funds, as they cannot be sure if and when funds will be available to undertake necessary investments and activities. In very poor countries that depend heavily on aid for provision of basic services (such as education or health care services), disruptions in aid flows can have very serious effects on the welfare of the population groups affected by the aid cuts.
Factors that limit the effectiveness of Official Development Assistance (ODA) - Unco-ordinated donors
In any recipient country there are usually large numbers of donors (bilateral and multilateral) who finance unco-ordinated activities, giving rise to numerous inefficiencies in the use of aid resources. Sometimes the numbers of aid-funded projects are in the hundreds. Lack of co-ordination of such projects results in overlapping and duplication of some projects, inconsistencies between other projects, and the lack of coherence in the entire aid effort.
Factors that limit the effectiveness of Official Development Assistance (ODA) - Aid may substitute for rather than supplement domestic resources
Aid resources are intended to supplement insufficient domestic resources. A possible danger is that governments in recipient countries may use aid funds to substitute for domestic resources, and not make enough effort to increase domestic revenues through taxation. The evidence on this issue is mixed; whereas some countries have been unable to raise tax rates in spite of growth, others have succeeded in increasing tax revenues even as aid increases rapidly.
Factors that limit the effectiveness of Official Development Assistance (ODA) - Aid may not reach those most in need
Aid resources are not allocated on the basis of the greatest need for poverty alleviation. There are two aspects to this issue: the distribution of aid funds across countries, and the use of aid funds within recipient countries. We have already seen in connection with the first that bilateral donors do not always allocate aid resources according
to country needs. The second, involving the use of aid funds within countries, is related to a number of factors: recipient country governments may not be genuinely committed to poverty alleviation; they may lack the necessary expertise to design and implement poverty alleviation policies; tied aid may favour projects that are not appropriate for poverty alleviation; donors may select projects that are not the most effective from the point of view of poverty alleviation.
Factors that limit the effectiveness of Official Development Assistance (ODA) - Aid may be associated with corruption
Corruption involves misuse of aid funds by recipient countries, and is a key problem associated with the provision of aid. Corruption is a reflection of the degree of transparency and accountability in public affairs, and tends to be more prominent the lower the per capita income of a country.
Factors that limit the effectiveness of Official Development Assistance (ODA) - The quantity of aid and poverty alleviation
Donors have repeatedly promised to allocate 0.7%
of their GNI for ODA. A few countries more than meet this target. However, others do not, and since some of these are among the larger and wealthier donors, it means that overall ODA funds are far less than the target amount. According to the United Nations Development Programme, if rich countries fail to follow through on their commitments, developing countries will be unable to make the investments in health, education and infrastructure needed to improve welfare and support the economy on the scale required to achieve the MDGs.
Advantages of NGO: why NGOs are growing in importance - summary
More and more bilateral and multilateral donors of ODA are channelling their funds through NGOs because of their ability to perform some functions better than developing country governments. The reasons for better performance include:
1. Strong anti-poverty orientation of activities
2. Working closely with project beneficiaries
3. Contributing to democratisation
4. Offering expertise and advice
5. Ability to be innovative
6. Independent assessment of problems and pursuit of solutions
7. Enjoying the trust of beneficiaries
8. Advocacy and raising public awareness and support
Advantages of NGO: why NGOs are growing in importance - Strong anti-poverty orientation of activities
NGO activities are for the most part concerned with reaching poor people and helping them emerge from their poverty. Governments often have difficulties in reaching the very poor; NGOs have an advantage by working very closely with communities of poor people and responding to their particular needs as these arise in their own particular economic, social and environmental conditions.
Advantages of NGO: why NGOs are growing in importance - Working closely with project beneficiaries
One of the strongest advantages of NGOs is that they work closely with their beneficiaries, involving local people in the design and implementation of development projects. Involvement by local people allows them to provide inputs into deciding what problems should be addressed and how they should be solved, and gives them a sense of ownership and commitment to the project, all of which contribute greatly to success. Moreover, this approach contributes to the promotion of self-help and mutual assistance in problems of development.
Advantages of NGO: why NGOs are growing in importance - Contributing to democratisation
Such participatory practices contribute to a process of democratisation, which can be important in countries that do not have democratic institutions.
Advantages of NGO: why NGOs are growing in importance - Offering expertise and advice
International NGOs accumulate experience from a variety of countries and local settings, many of which may be relevant and transferable to similar settings in other countries. They recruit experts in a variety of areas in accordance with need, and the experts are highly motivated out of a strong commitment to the objectives of the NGO with which they are affiliated.
Advantages of NGO: why NGOs are growing in importance - Ability to be innovative
Unlike governments, which often take a uniform approach to problems, NGOs, by working closely with their beneficiaries, can be more creative and innovative in devising solutions to very specific problems that arise in local settings.
Advantages of NGO: why NGOs are growing in importance - Independent assessment of problems and pursuit of solutions
Unlike government programmes, which must conform to general policy guidelines and are subject to following government agendas, NGOs have a greater degree of freedom to use their expertise and technical knowledge to assess problems independently and arrive at suggestions for solutions. In addition, NGOs also enjoy more freedom because their activities are not subject to the conditions often imposed by donors of aid (conditionality); and they are not subject to the restrictions associated with tied aid.
Advantages of NGO: why NGOs are growing in importance - Enjoying the trust of beneficiaries
Poor people are often highly suspicious and mistrusting of government officials and administrators, feeling at best neglected and at worst exploited. NGOs sometimes enjoy greater trust than governments, because of their close relationship with project beneficiaries, and their commitment to solving problems at grassroots level.
Advantages of NGO: why NGOs are growing in importance - Advocacy and raising public awareness and support
Poor people usually lack political voice and representation, and their concerns are not heard at higher government levels. NGOs play an important leadership role in acting as advocates on public policy issues, and ensuring that poor people's concerns are heard.
Criticisms of NGOs - summary
1. Small size and weakness of many NGOs
2. Possible loss of independence due to growing dependence on governments and aid agencies for funding
3. NGOs may attract the best qualified personnel away from government
4. Challenge to state authority
Criticisms of NGOs - Small size and weakness of many NGOs
NGOs may be too small and weak to be able to play an important role as agents of change and development. They often have limited resources, and may face difficulties in attracting skilled personnel, so that the effectiveness of their projects may be limited.
Criticisms of NGOs - Possible loss of independence due to growing dependence on governments and aid agencies for funding
One of the potential strengths of NGOs is their ability to act independently, free of constraints imposed by governments, aid agencies and bilateral and multilateral donors. However, as they become more and more dependent on these outside sources for their funding, they may lose their independence if they are forced to conform to the demands of funders.
Criticisms of NGOs - NGOs may attract the best qualified personnel away from government
The growing role of NGOs in development creates a demand for technical experts and personnel that may deprive governments of scarce highly qualified personnel, as NGOs are often in a position to offer higher salaries and benefits than the government.
Criticisms of NGOs - Challenge to state authority
Whereas governments generally welcome NGOs that complement their activities in poverty alleviation, they often dislike the advocacy role taken on by many NGOs, which may conflict with government policy or question its authority.
The consensus view on NGOs overall is favourable. However, NGOs must act in partnership with the government, and must not be considered to be a replacement of government. Governments have crucial roles to play in the development process, which NGOs, even under the most favourable circumstances, cannot possibly undertake.
Governments are essential for establishing an overall policy framework for the economy, including a framework for sustainable development; for providing a legal, institutional and regulatory framework for the economy; for pursuing policies to ensure economic stability; and for correcting market failures.
Compare and contrast the roles of aid and trade in economic development
There has been an ongoing debate for decades regarding the relative roles of foreign aid and international trade in economic growth and development. We will examine the controversy by considering three popular slogans, each representing a different perspective:
• 'trade, not aid'
• 'trade and aid'
• 'aid for trade'
Arguments supporting the 'trade, not aid' perspective
Supporters of the 'trade, not aid' perspective argue that development should be based on an expansion of international trade and increasing exports of developing countries, while aid should be limited if not altogether abandoned. The arguments centre on two main points:
1. the failures of aid to effectively address the problem of growth and development
2. the ability of trade to make major contributions to growth and development, provided rich countries abandon their protectionist policies.
Regarding the failures of aid, its critics emphasise the dangers of corruption, the idea that aid replaces government funds rather than supplementing them, and that because of corruption and mishandling, aid does not reach those most in need. The conclusion is that, in spite of several decades of experience during which rich country governments have spent billions of dollars on aid, many countries are still as poor as ever. Aid has therefore failed to contribute to growth and development, and to poverty alleviation.
In contrast to aid, international trade can
make important contributions to growth and development and poverty alleviation, as shown by the highly successful growth and development performance of East Asian countries. However, if developing countries are to exploit their trade potential to the benefit of their growth and development, developed countries should eliminate their trade protection policies, as well as protection of their agricultures.
Arguments supporting the 'trade and aid' perspective
Supporters of 'trade and aid' argue that while trade and export growth are very important for growth and development, they are not enough in the case of low- income (very poor) developing countries.
Many of the serious weaknesses of aid are the responsibility of donors. These include tied aid, conditionality of aid, volatility and unpredictability
of aid, and lack of donor co-ordination of aid.
There is strong pressure on donors by aid organisations to correct these problems, to make aid more effective.
At the same time, there are some situations where international trade may be unable to help, making aid necessary.
Arguments supporting the 'trade and aid' perspective - what are the situations where aid is necessary
1. Rich country agricultural subsidies. As long as these are in place, developing countries that depend on exports of protected goods cannot rely on trade to grow and develop.
2. Developing country dependence on commodity exports. Some of the poorest countries in the world depend on production and export of primary commodities and are hurt by price volatility and deteriorating terms of trade. These countries cannot grow and develop by use of trade.
3. The poverty cycle. Countries trapped in the poverty cycle cannot escape from this by means of trade.
4. Countries may have little to export. Many poor countries cannot take advantage of trade opportunities because they have difficulties moving into new areas of production of goods that can be exported. Limited access to credit is a major obstacle to opening up a new business that produces for export. Aid is therefore essential to help such countries develop the necessary institutions that will help them move into production for export.
5. Exclusion of geographically isolated communities and countries. There are many poor communities, particularly in landlocked countries, which are geographically isolated and have no access to markets, to urban centres or to ports. It is very difficult for the people in these communities to be integrated into the market economy, much less to participate in the benefits of increasing exports. Geographical isolation makes countries such as these, or isolated communities within countries, unable to compete in international markets, and therefore unable to take advantage of the potential benefits of trade in the absence of major investments in communications and transportation, which can be greatly facilitated by the provision of aid.
Arguments supporting the 'aid for trade' perspective
More and more economists believe that to be able to benefit from international trade, developing countries must have the institutional capacity to increase their exports.
This perspective is an extension of the 'trade and aid' perspective; it asserts that both trade and
aid are important to growth and development, and, in addition, aid and trade should be linked together so that a portion of aid is used to support the development of institutions that improve a country's abilities to export. This view is based on the idea that many poor countries face institutional constraints that prevent them from taking advantage of growing international markets. Even if all rich country trade protection disappeared overnight, countries that do not have the institutions enabling them to increase and diversify their exports will experience limited benefits from trade.
The constraints faced by developing countries include everything from high transport costs due to poor transport networks, limited access to credit, poor power supplies adding to costs of production, high administrative costs related to complicated border procedures, and lack of institutional capacity to meet technical and sanitary standards increasingly required by importing countries.
This approach requires that aid and trade policies be integrated, so that a policy geared toward increasing exports is based on assistance aiming to strengthen the abilities of developing countries to achieve increases in exports. The 'aid for trade' would be in addition to, and not a replacement of Official Development Assistance (ODA) funds. Moreover, efforts to address institutional constraints to trade should not concentrate only
on very poor developing countries (which receive ODA funds), but also on middle-income developing countries (which do not qualify for ODA funds).
Definition of Multilateral development assistance
Multilateral development assistance involves lending to developing countries on non-concessional terms, in other words with rates of interest and repayment periods determined in the market.
Who are the major multilateral lenders to developing countries?
There are a number of major multilateral lenders to developing countries such as:
1. multilateral development banks,which lend in order to support economic growth and development, including the:
- World Bank
- African Development Bank
- Asian Development Bank
- Inter-American Development Bank
- European Bank for Reconstruction and Development
2. the International Monetary Fund, which lends in order to alleviate external payments difficulties.
Lending by both multilateral development banks and by the International Monetary Fund differ from commercial bank lending because they are involved with lending for economic development or international financial stability, rather than for commercial or profit reasons.
Definition of the World Bank
The World Bank is a development assistance organisation that extends long-term loans to developing country governments for the purpose of promoting economic development and structural change. It was established in 1944, at the end of the Second World War, as part of an effort to help reconstruct Europe. It consists of two organisations:
1. the International Bank for Reconstruction and Development (IBRD), which lends on non- concessional (i.e. commercial) terms to middle income developing countries, therefore its activities and lending do not form part of foreign aid; by far the greatest part of World Bank lending for development purposes (about 75%) is offered by the IBRD, and for this reason the World Bank, for the most part, is not considered to be an aid agency.
2. the International Development Association (IDA), established in 1960, which has similar activities to the IBRD but extends loans to low income countries on highly concessional terms.
The importance of the World Bank as a development assistance organisation lies mainly in its role as a lender of funds to governments, and therefore focuses on the roles of the IBRD and IDA.
Brief history of World Bank activities
The World Bank's activities have changed their focus over the years. In the early years of its involvement with developing countries, the World Bank focused on lending for the development of infrastructure, such as energy, transport, telecommunications and irrigation.
In the early 1970s, the World Bank turned its attention towards poverty alleviation.
At the end of the 1970s and in the early 1980s,
the Bank's focus changed once more to a new type of lending: structural adjustment loans (SALs) intended
to change the course of policy-making in developing countries by reducing government intervention and promoting competition and the role of markets. SALs came under very strong and widespread criticism because of their negative consequences on developing country economies.
Current World Bank activities
Since the mid-1990s, the World Bank has again shifted towards a poverty orientation, and has committed
itself to helping countries achieve the Millennium Development Goals. It also began to focus on sustainable development. Its poverty-oriented projects are meant to be environmentally sustainable. In addition, the World Bank has changed its views on the appropriate role of government in economic growth and development. According to the new perspective, poverty alleviation requires intervention by governments in many areas. The World Bank is also paying increasing attention to the need for institutional development, based on the idea that markets need institutions that provide education and health services; ensure availability of and access to necessary infrastructure.
Evaluating the role of the World Bank - summary
1. Social and environmental concerns
2. World Bank governance dominated by rich countries
3. Excessive interference in countries' domestic affairs
4. Conditional assistance (lending)
5. Damaging effect on developing countries
6. Inadequate attention to poverty alleviation
Evaluating the role of the World Bank - Social and environmental concerns
TheWorld Bank has been criticised for implementing socially unsound projects (such as building hydroelectric dams that displace indigenous people), as well as environmentally unsustainable projects (such as building infrastructure that destroys the natural environment and local ecosystem). In recent years, the World Bank has become far more aware of the social and environmental implications of the projects it funds, and currently makes greater efforts to ensure that project objectives are consistent with social and environmental concerns.
Evaluating the role of the World Bank - World Bank governance dominated by rich countries
The World Bank is owned by its 185 member states; however, voting power in its governance is determined by the size of financial contributions made by each country to the organisation, which are in proportion to the size of each economy. This clearly gives far greater power to rich countries. Critics argue that decisions are made without due regard for the needs and wishes of developing countries, which, being the poorest, have the least representation in decision-making.
Evaluating the role of the World Bank - Excessive interference in countries' domestic affairs
Critics argue that the World Bank interferes excessively in the domestic policy affairs of developing countries.
Evaluating the role of the World Bank - Conditional assistance (lending)
Conditional assistance (or conditional lending) refers to the imposition of conditions that must be met by borrowing countries to qualify for a loan. (It is also one of the problems of foreign aid.) The World Bank sees the imposition of conditions as a mechanism for inducing desirable policy changes. Conditional lending is problematic because it deprives countries of control over their domestic economic activities.
Evaluating the role of the World Bank - Damaging effect on developing countries
One of the strongest criticisms involves the negative effects on developing country economies of structural adjustment lending. SALs have been criticised for increasing income inequalities and poverty within developing countries, because of such factors as increasing unemployment, cuts
in provision of merit goods by governments, cuts
in food subsidies, introduction of payments of fees for health and education, and limited possibilities for the poor and the unskilled to take advantage of opportunities opened up by the freer market environment. Increasing poverty is considered by many to be among the World Bank's greatest failures.
Evaluating the role of the World Bank - Inadequate attention to poverty alleviation
Although the World Bank has in recent years turned its attention to poverty issues, critics argue that it is not doing enough to meet the challenges of extreme poverty in developing countries by not allocating enough funds for loans intended to meet the needed investments in education, health services, and infrastructure (clean water supplies, sanitation, etc.). In addition, it has been criticised for not doing enough in the area of debt relief through the Heavily Indebted Poor Countries (HIPC) Initiative; many very poor and highly indebted countries do not qualify for debt relief because, according to requirements for eligibility established by the World Bank, they are not poor enough or indebted enough. The result is that a number of countries do not receive the assistance they require.
Definition of International Monetary Fund (IMF)
The International Monetary Fund (IMF) is a multilateral financial institution that was established jointly with the World Bank in 1944 with the original purpose of lending to countries experiencing balance of payments deficits under the system of fixed exchange rates that existed at the time. Its objectives have changed over the years in accordance with the evolution of the international financial system. At the present time, the IMF is composed of 185 member countries. Its purpose is to oversee the global financial system, follow the macroeconomic policies of its member countries, stabilise exchange rates and help countries that experience difficulties making their international payments by extending them short-term loans on commercial (i.e. non-concessional) terms.
Activities of the International Monetary Fund
In the first two decades of IMF's existence, more than half of its lending was to developed countries. Its role in developing countries grew with the debt crisis beginning in the 1970s and 1980s. This was the time when many poor oil-importing countries developed serious balance of payments difficulties as a result of dramatic increases in oil import expenditures.
During the 1990s, the IMF expanded its lending to transition economies in central and eastern Europe and the former Soviet Union. Since 2008 its lending has increased significantly to countries around the world as a result of international payments difficulties brought on by
the global financial crisis, including some developed countries (Greece, Iceland, Ireland, Portugal).
What are stabilisation policies?
The loans provided by the IMF usually come with a package of policies that the country must adopt as a condition for receiving the loan (another example of conditionality). These policies, known as stabilisation policies, vary from country to country, but typically include the following:
1. tight monetary policy, through increases in interest rates, intended to lower aggregate demand, reduce
the level of economic activity and reduce demand for imports while encouraging inflows of financial capital, thereby helping the balance of payments position.
2. tight fiscal policy, also intended to lower aggregate demand and reduce the level of economic activity, through cuts in government spending (including cuts in provision of merit goods, such as health services, education, infrastructure, etc.) and cuts in food and other subsidies, as well as increases in taxation, and the imposition of fees for schooling and health care services.
3. currency devaluation or depreciation, intended to discourage imports and encourage exports and help the balance of payments position.
4. cuts in real wages (i.e. wages after taking into account the impact of price changes), to reduce aggregate demand and the level of economic activity.
5. liberalisation policies, such as eliminating or reducing controls on prices, interest rates, imports and foreign exchange, to promote a free market and free trade environment.
Evaluating the role of the International Monetary Fund - summary
The IMF is a far more controversial institution
than the World Bank, and is subject to more
intense criticism due to the highly negative impact on countries that almost always results from its stabilisation policies. While it shares some of the criticisms against the World Bank, the main criticism focuses on the harshness of the measures that borrowers are forced to adopt. The criticisms may be summarised as follows:
1. IMF governance dominated by rich countries
2. Excessive interference in countries' domestic affairs
3. Conditional lending (conditionality)
4. Damaging effects on developing countries
5. IMF stabilisation policies based on a flawed concept
Evaluating the role of the International Monetary Fund - IMF governance dominated by rich countries
As with the World Bank voting power in its governance is in proportion to the size of each economy, giving rich countries far greater power in decision-making.
Evaluating the role of the International Monetary Fund - Excessive interference in countries' domestic affairs
Even more than in the case of the World Bank, critics argue that IMF interference in domestic economies is far too great.
Evaluating the role of the International Monetary Fund - Conditional lending (conditionality)
Loans are made available only on condition that the borrowing country agrees to implement the stabilisation policies designed by the IMF. Given their vulnerability in times of severe external payments difficulties, countries are forced to accept harsh conditions that run counter to their growth and development objectives.
Evaluating the role of the International Monetary Fund - Damaging effects on developing countries
IMF policies come at an immense human cost. Stabilisation policies have the impact of lowering economic growth, often creating a recession with increasing unemployment and increasing levels of poverty. In developing countries that in any case face high unemployment and underemployment, the effects can be devastating. Cuts in real wages where wages are low to begin with, cuts in government spending on merit goods and food subsidies on which many poor people depend for their physical survival, the imposition of fees for schooling and health care services among people who cannot afford them, along with the increases in poverty that arise from liberalisation policies, are wholly inconsistent with economic growth and development objectives.
Evaluating the role of the International Monetary Fund - IMF stabilisation policies based on a flawed concept
Some economists argue that in addition to the human cost, there may be something fundamentally wrong with the stabilisation concept pursued by the IMF. The reason is that whatever success the IMF stabilisation policies have had in alleviating external payments problems, the success tends to be short-lived. The fundamental balance of payments problem of many developing countries does not get resolved through IMF loans and restrictive macroeconomic policies. Experience shows that many countries that have tried the IMF programme suffer not only increasing poverty but also low or negative rates of growth, and therefore are unable to 'grow' out of their balance of payments difficulties or external debt problems.
The meaning of foreign debt
A country's foreign debt refers to its level of external debt, meaning the total amount of debt (public and private) incurred by borrowing from foreign creditors (i.e. lenders).
The problem of developing country debt involves large volumes of public (i.e. government) debt. Foreign government debt arises from three sources: (i) government borrowing from multilateral organisations, (ii) government borrowing from foreign commercial banks, and (iii) government sales of bonds to foreigners.16
Borrowing has major costs, which take the form of 'debt servicing'; this involves payment of the principal (the amount of the loan) plus interest. When a country borrows from a foreign creditor, the debt service payments must be
made in foreign exchange, which can come from increased exports, reduced imports, or financing from external sources.
Under favourable circumstances, debt service payments are made possible by greater economic growth and increased export earnings.
Why countries borrow from foreign sources
Borrowing from foreign sources enters the balance
of payments as a credit in the financial account and helps countries pay for deficits (an excess of debits) in the current account. Therefore, a very important reason why countries borrow from abroad is to acquire foreign exchange allowing them to pay for an excess of imports over exports (a trade deficit). A trade deficit allows a country to reach a point outside its production possibilities curve (PPC), meaning it enjoys more goods and services than it can produce itself, but this means it must have a method of paying for the extra goods and services; borrowing from abroad is one method allowing it to do this.
The rationale, over the longer term, is that countries will spend at least a portion of imports made possible by foreign finance on capital goods that are inputs in production, which will accelerate their growth and their exports, so that over the longer term they will be able to pay back their debts plus interest.
Yet the developing countries suffering today
from high levels of debt have been victims of an unfortunate set of circumstances: low growth in export earnings, higher import costs, lower than expected (and sometimes negative) rates of economic growth, as well as increasing interest rates (which increase the cost of debt servicing). These circumstances give rise to serious problems in the balance of payments, resulting in an ever-growing need for foreign borrowing.
ONE example of how some developing countries became heavily indebted
The beginnings of the debt problem date back to the oil shock of 1973-74, when the Organization of the Petroleum Exporting Countries (OPEC) suddenly increased the price of oil. Almost overnight, oil- importing developing countries were faced with larger import expenditures due to higher oil prices. In addition, they faced lower export revenues because the oil price increases created recessions (stagflation) in developed countries, resulting in a lower demand for developing country exports. These two events resulted in larger trade and current account deficits in developing countries, creating a need for increased foreign borrowing that would provide the foreign exchange needed to cover their deficits.
A related event made it easier for developing countries to borrow more. After the oil price increases the OPEC nations found themselves with much larger oil revenues, much of which they deposited in commercial banks in developed countries, mainly in the United States, Europe and Japan. The commercial banks, seeing very large increases in their supply of loanable funds, began aggressively competing with each other to lend to developing countries. The developing countries' need for new loans coincided with the international banking system's need to make new loans. This lending pattern came to be known as 'petrodollar recycling', involving commercial banks lending to oil-importing countries the same funds that came from oil exporters, to allow the developing countries to continue to import oil.
What happens to help prevent developing country defaults - summary
1. Debt rescheduling
2. IMF lending and stabilisation policies
3. World Bank lending and structural adjustment loans
4. Other initiatives: debt-for-equity swaps
What happens to help prevent developing country defaults - Debt rescheduling
One of these measures was debt rescheduling (restructuring), involving new loans by commercial banks to developing country debtors, but on better terms. Debt rescheduling did not include debt forgiveness, as the loan still had to be paid back in full; it involved granting of new loans that were stretched out over longer periods of time and at lower interest rates. The loans were used to pay off some of the old loans, and therefore ease the pain of having to service the debts.
What happens to help prevent developing country defaults - IMF lending and stabilisation policies
A second measure involved turning to the International Monetary Fund (IMF) for loans that would help cover large and growing current account deficits. The role of the IMF in this regard was explained on page 518 above. The loans were conditional in that they were made only if the borrowing country government agreed to pursue stabilisation policies prescribed by the IMF (tight fiscal and monetary policies, liberalisation policies, etc.).
What happens to help prevent developing country defaults - World Bank lending and structural adjustment loans
At the same time that countries turned to the IMF, they often also borrowed from the World Bank, which also made conditional loans. These were the structural adjustment loans (SALs), which forced the borrowing country government to pursue economic and trade liberalisation policies to qualify for receiving a loan.
What happens to help prevent developing country defaults - Other initiatives: debt-for-equity swaps
Another measure involved 'debt-for-equity swaps'. This occurs when a highly indebted country exchanges a portion of its debt for equity, which is taken up by foreign corporations. What this means is that the foreign corporation takes responsibility for a portion of a government's debt, and in exchange the government gives it ownership of some of its assets (such as a telephone company or a steel mill). The indebted country benefits, because it can significantly lower the level of its debt by giving up some of its assets. Much of Latin American privatisation occurred this way. However, a key problem is that foreign corporations can be persuaded to engage in a debt-for-equity swap only if they acquire the state assets at a low price. As a result, governments lose control of some of their major assets to foreign-owned corporations at a price that is far lower than if these assets were sold at market prices.
Consequences of high levels of foreign debt - summary
1. Balance of payments problems
2. Possibility of a debt trap
3. Opportunity costs
4. Lower private investment
5. Lower economic growth
Consequences of high levels of foreign debt - Balance of payments problems
When a country borrows from foreign institutions, whether these are commercial banks or multilateral organisations like the World Bank and IMF, its debt servicing obligations (repayment of loan plus payment of interest) must be paid in foreign exchange. If its export earnings are not enough to cover its foreign exchange needs for debt servicing, it can borrow more from abroad to acquire the needed foreign exchange. However, as it borrows more, its debt servicing obligations increase. This means that there will be continuous pressure on the balance of payments and a constant quest for foreign exchange with which to service the debt.
Consequences of high levels of foreign debt - Possibility of a debt trap
As levels of debt rise, there comes a point where the level of debt cannot be sustained: new debt requires higher debt service payments, which require more foreign borrowing, which leads to more debt servicing payments, and so on, in a self-reinforcing spiral in which the country is trapped. This has been termed the 'debt trap', involving a situation where a country must keep on taking out new loans in order to pay back the old ones. Many countries, particularly in Latin America and Sub-Saharan Africa, were caught in a debt trap during the 1980s.
Consequences of high levels of foreign debt - Opportunity costs
Large debt service payments have major opportunity costs because the government has fewer resources to invest in social services (health, education, etc.) and infrastructure, all necessary for poverty alleviation and economic growth and development.
In addition, since a highly indebted country is forced to use a large portion of its export earnings for debt servicing, it has less foreign exchange to pay for imports of needed capital equipment, other production inputs and goods and services generally. The foregone imports are an additional opportunity cost with negative consequences for economic growth.
Consequences of high levels of foreign debt - Lower private investment
Fears that a government may be unable to service its debts create uncertainty regarding economic conditions and scare away private investors, both domestic and foreign. Even if investment does take place, it is more likely to involve short-term investment projects with quick returns, rather than longer-term ones with greater potentials to support economic growth.
Consequences of high levels of foreign debt - Lower economic growth
The above three factors, lower public investments in merit goods, lower imports of production inputs and lower private investment, work to lower economic growth in highly indebted countries. This in turn translates into a reduced ability to service debts.
Explain that the burden of debt has led to pressure to cancel the debt of heavily indebted countries
The difficulties caused by high levels of debt have led to pressure on creditors to cancel debts of highly indebted countries.
To qualify for debt cancellation, countries must have a per capita GNI below a particular level; they must have a debt level that cannot be sustained (i.e. they must be in a debt trap); they must show evidence that they are following certain elements of IMF and World Bank policies (such as cutting government expenditures and liberalising their markets); and they must commit themselves to pursuing a poverty reduction strategy. The funds made available through debt relief, in other words the country's savings from debt reduction, must be spent on projects that attack poverty, such as the development of rural infrastructure, providing health services and education, creating new jobs, and providing family planning services.
Why the HICP Initiative has been criticised
The HICP Initiative is considered to be a welcome step in the direction of solving the debt problem, but has been criticised for several reasons:
1. The level of debt reduction which the programme makes possible (level of debt is to be reduced to 150% of exports) is considered insufficient; if a country's export earnings fall for whatever reason, it risks sliding back towards a debt trap.
2. The programme takes effect too slowly, risking that the benefits of debt relief may follow too slowly to be of much use to the countries.
3. Some measures that are imposed as conditions for a country to qualify are too severe (for example, charging fees for schools and hospitals, privatising key public enterprises such as electricity and telephone, reductions in government expenditures that reduce the provision of social services and infrastructure).
4. There are many other countries that are highly indebted but which have not been included in
the HIPC Initiative; these countries, whose debt situation is considered to be more manageable, are still suffering the consequences of high levels of debt, yet are unable to benefit from debt relief.