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Carmen Reinhart and Kenneth Rogoff (2004:53–58) have another explanation for the paradox of poor to rich capital flows: the prime role of political and credit-market risk in many LDCs. They show that the number of years a country has been in default during the last 55 to 60 years is central in explaining capital flows and per-capita income levels. Ironically, the true paradox, they indicate, may be that “too much capital . . . is channeled to ‘debt-intolerant’ serial defaulters.”

Massive Capital Inflows to the United States

The major example of counterintuitive capital inflows is that to the United States. Since the last quarter of 1985, the United States has been the world’s largest international debtor. By the end of 2003, the U.S. gross external debt, a stock concept that represents the accumulation over time of international deficits, was $6,800,485 million (U.S. Treasury 2003).

Indeed, in 2000, the peak year of the business cycle, the U.S. current account deficit was financed by 8 percent of the combined savings of the rest of the world! By 2003, the deficit represented 10 percent of the rest of the world’s savings (World Bank 2003e:37).

How can we explain this? Because of the widespread use of the dollar for international payments and reserves, global companies and central banks have accumulated dollar assets amid the United States’ persistent balance on goods, services, and income deficit.

The United States was able to do this because it has been the world’s major reserve and trading currency. Unlike Argentina, Thailand, and Nigeria, the United States has borrowed its funds in its own currency, U.S. dollars, at relatively low interest rates. As pointed out in Chapter 17, the United States has had a persistent surplus (comparative advantage) in the trade of services and financial assets. U.S. rapid productivity growth, at least in the 1990s, from cheaply coordinating global value-added steps into final assembly and sales, increased foreigners’ expectations of high rewards from their investments. Productivity growth made U.S. assets extremely attractive to both domestic and international investors (Mann 1999). As a balance of payments statement similar to Table 15-1 points out, the U.S. capital account, that is, capital inflows and the rest of the world’s increased holding of U.S. assets, a flow concept, equals the current account, a major component of which has been the trade deficit.

The opportunity cost of investment forgone in the LDCs’ domestic development is substantial. Furthermore, exporters to the United States or those competing with those selling at dollar prices suffered terms of trade losses, whereas nonoil exporters priced in currencies other than dollars enjoyed terms of trade benefits, including price gains when importing petroleum, priced in dollars.

Economists such as Catherine Mann think the continuing deficit in the United States is unsustainable, partly as interest and dividends to service the debt increases as U.S. liabilities to foreigners rise. In addition, some world’s asset holders may shift from the U.S. dollar as reserve currency and medium of exchange to other currencies, such as the euro, the common currency created by the 12 members of the

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European Economic and Monetary Union (a subset of the European Union) in 1999, a move that may weaken the dollar. Foreign central banks, who financed 38 percent of the U.S. current account deficit in 2003 (Ip 2004:A2), or other foreigners could eventually stop providing credit to the United States, which would have to reduce consumption to increase investment and reduce its foreign debt. In any event, the continuing external deficit makes the United States vulnerable to the confidence of foreign asset holders (Alan Greenspan, Speech, November 19, 2004).

Conclusion

Globalization involves the expansion of economic activities across nation states, deepening economic openness, integration, and interdependence among countries. External openness generally benefits most of the world but is likely to marginalize peripheral countries, especially their poorest citizens.

A capital inflow enables a country to invest more than it saves and import more than it exports. A newly industrializing country that effectively uses an inflow of foreign funds should usually be able to pay back its debt from increased output and productivity.

Exports minus imports of goods and services equal the international balance on goods, services, and income. Aid, remittances, loans, and investment from abroad finance a balance on goods and services deficit.

Countries give concessional aid to LDCs for reasons of national economic and political interest, ideology, humanitarianism, and global political maintenance.

In 2001, aid from Organization for Economic Cooperation and Development (OECD) countries (the West and Japan) fell to $51.4 billion, 0.22 percent of GNP. Aid given by the United States, the largest giver, was also lowest as a percentage of GNP. The grant component of OECD concessional aid to LDCs was 94 percent.

The major multilateral agencies providing concessional aid to LDCs were the International Development Association (a World Bank affiliate), the Commission of the European Communities, and the United Nations.

A large share of international trade is multinational corporations’ intra-firm trade. Although the United States still accounts for the largest share of the world’s foreign, private investment, its share steadily declined between 1971 and 2001.

The largest multinational corporations have an economic strength comparable to that of the LDCs with which they bargain. In 2001, the top 10 recipients received 73 percent of inward foreign direct investment (FDI). China was the leading LDC recipient of FDI.

Although MNCs in developing countries provide scarce capital and advanced technology for growth, doing so may increase LDC dependence on foreign capital and technology. The LDCs need a judicious combination of MNCs, joint MNC–local ventures, licensing, and other technological borrowing and adaptation.

Loans to developing countries at bankers’ standards fell from 1990 to 2002. Why doesn’t capital flow from rich to poor countries? LDC capital markets are

imperfect and often subject to political risk.

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Why does 10 percent of the rest of the world’s savings flow to the United States? The United States has the most highly developed market for financial assets, and attracts savings as the world’s largest reserve and trading currency.

TERMS TO REVIEW

aid (official development assistance)

antiglobalization

average propensity to remit

bilateral aid

capital import

concessional funds

current account

direct investment

euro

eurocurrency

eurodollars

fungible

General Agreements on Tariffs and Trade

globalization

global public goods

international balance of payments statement

QUESTIONS TO DISCUSS

international balance on goods and services

International Development Association (IDA)

International Monetary Fund (IMF)

investment

multilateral aid

multinational corporations

oligopoly

Organization for Economic Cooperation and Development (OECD)

portfolio investment

public goods

remittances

turnkey projects

vertical integration

World Bank

hawala system

1.Using national income equations, explain an inflow of capital from abroad in terms of expenditures–income, investment–saving, and import–export relationships. Indicate the relationships between expenditures and income, investment and saving, and imports and exports for a country paying back a foreign loan. Does repaying the loan have to be burdensome?

2.What is globalization? What are the similarities and differences between globalization, 1870–1913, and that after 1950? How much has the world’s people gained from globalization? What about LDCs? Which groups are the major winners and which the main losers?

3.To what extent does the Brandt Commission’s view of DC and LDC interdependence conflict with Frank’s view of LDC dependence?

4.How can foreign aid, capital, and technology stimulate economic growth? How could the roles of foreign aid, capital, and technology vary at different stages of development?

5.What are Chenery and Strout’s two gaps? How do foreign aid and capital reduce these two gaps? What are the strengths and weaknesses of the two-gap analysis?

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6.What are sources for financing an international balance on goods and services deficit? Which was the most important source for LDCs in the 1990s?

7.How effective has DC aid been in promoting LDC development? How effective has food aid been?

8.What are the costs and benefits for donor countries giving aid to LDCs? Do the costs outweigh the benefits? Choose one donor country. What are the costs and benefits for this country giving aid? Do the costs outweigh the benefits?

9.What is the trend for OECD aid as a percentage of GNP in the last two decades?

10.Compare economic aid to lowand middle-income countries since the 1980s? How do you explain changes in allocation over time?

11.How important was multilateral aid as a percentage of total economic aid in the last two decades?

12.What can LDCs do to increase direct foreign investment in their countries?

13.What are the costs and benefits to LDCs of MNC investment? How has the balance between costs and benefits changed recently?

14.What was the trend in the ratio of official aid relative to commercial loans to LDCs in the last three to four decades? How important is multilateral lending as a source of nonconcessional loans?

15.How important has the World Bank been as a source of funds for LDCs? How important has the IMF been as a source of funds for LDCs? Do you think there should be any changes in World Bank and IMF programs and conditions?

GUIDE TO READINGS

There are a plethora of reports by international agencies related to Chapters 15– 17 on the international economics of development. Annual publications include the World Bank’s World Development Report, World Development Indicators, Global Economic Prospects, and Global Development Finance; UNCTAD’s World Investment Report, Trade and Development Report, and Least Developed Countries; IMF’s

World Economic Outlook (also balance of payments data by world region); OECD’s

Development Cooperation and OECD in Washington: Recent Trends in Foreign Aid (consult source in Bibliography); and corresponding CD-ROMs. The Institute of International Economics in Washington, D.C. (http://www.iie.com) provides papers and speeches and lists many monographs on the balance of payments, aid, and FDI.

For discussion of the meaning of globalization and some historical parallels to contemporary globalization, see Nayyar (1997). Rodrik (1998) discusses how globalization has increased social tensions. Other economists on globalization include Nayyar, ed., Governing Globalization (2002), Stiglitz and Muet, eds., Governance, Equity, and Global Markets (2001), Bhagwati, In Defense of Globalization (2004), Stiglitz, Globalization and Its Discontents (2002b), Chang, ed., Joseph Stiglitz and the World Bank: The Rebel Within (2001), and World Bank, Globalization, Growth, and Poverty (2002). The listserv World Bank Development News is a good source to keep up on recent developments.

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Easterly (2001a) critiques World Bank and U.S. aid. World Bank (2000a:Chapter 8) discusses African aid dependence, poverty-reducing aid, aid delivery, and aid outcomes, and World Bank (2002a) makes the case for Bank aid. IFPRI’s Web site, http://www.ifpri.org, has information on sources on food aid. The U.S. Agency for International Development Web site is http://www.usaid.gov/.

Abhijit Banerjee, Esher Duflo, Sendhil Mullainathan, Marianne Bertrand, and Harvard’s Michael Kremer, at MIT’s Poverty Action Lab, use randomized experiments to test the effectiveness of aid projects. Duflo found that providing poor Kenyan students with free uniforms or a porridge breakfast increased school attendance but that drugs to treat intestinal worms, a cost of $3.50 for a year’s schooling, was even more cost-effective. Mullainathan, in a project to test job discrimination in Boston and Chicago, found that applicants with white-sounding names (such as Emily Walsh or Brendan Baker) were more likely to receive requests for interviews than those with black-sounding names (such as Lakisha Washington or Jamal Jones) (Dugger 2004; Poverty Action Lab 2004).

16 The External Debt and Financial Crises

Scope of the Chapter

Chapter 15 mentioned that the LDCs’ persistent deficit on the balance on goods, services, and income through the 1980s and 1990s, together with a decline in loans at bankers’ standards in the midto late 1990s, contributed to a continuing LDC debt crisis. The debt crisis for Latin America and other middle-income borrowers, primarily owed to commercial lenders, was of a different nature than that of subSaharan Africa, who owed its debts primarily to bilateral government and multilateral lenders. Jubilee 2000, launched by nongovernmental organizations, put pressure on the World Bank, IMF, and DC donors to relieve, write down, or forgive the debts of the highly indebted poor countries (HIPCs), largely from Africa.

The most fundamental change in the international economic system in the 1990s was the incredible rise in international capital mobility, with about $2 trillion crossing borders daily (You 2002:216), from which middle-income countries received massive capital inflows. Global foreign exchange transactions rose from a mere $15 billion per day in 1973 to $60 billion in 1983, exploding to $900 billion in 1992, and continuing to increase in the years after that. Thus, the worldwide ratio of foreign exchange transactions to world trade was 9:1 in 1973, 12:1 in 1983, and 90:1 in 1992. World GDP in 1992 was $64 billion daily compared to $10 billion exports and $900 billion foreign exchange transactions, in excess of the foreign exchange reserves of the world’s central banks, $693 billion, inadequate to cope with sudden shifts in the direction of global currency flows (Nayyar 1997:3–4). Not surprisingly, financial crises occurred in Mexico (1994), Southeast and East Asia (1997–99), and Argentina (2001–03) following capital-account liberalization and substantial increases in capital inflows.

On the one hand, Ranciere, Tornell, and Westerman (2003) show that among 52 LDCs, financial liberalizers grew by 2 percentage points faster than nonliberalizers, with bank credit growth responsible for about half the advantage. Yet, on the other hand, East and Southeast Asian countries experiencing financial and currency crises suffered an output reduction from 1997 to 2001 worse than the Great Depression. Still, despite Thailand’s depression during the 1997–99 financial crisis, its growth in GDP per capita was 4.5 percent yearly, 1980–2001, compared to India’s 3.3 percent annual growth for the same period (Economist 2003h:77), a cumulative growth difference of more than 50 percent.

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TABLE 16-1. Total External Debt of LDCs (selected years, 1970–2001, in $ billions)

1970	49
1976	157
1982	816
1984	908
1986	1216
1989	1411
1992	1662
1995	2066
1998	2395
1999	2427
2000	2364
2001	2322

Sources: Organization for Economic Cooperation and Development 1988:218; World Bank 1978i:96–97; World Bank 1988i:258–259; World Bank 1993i:170–171; World Bank 2003e.

This chapter examines both debt and financial crises, despite their differences in origin. We also discuss the definition of external debt, the origins of the debt crisis, how capital flight exacerbates the debt problem, the U.S. bankers’ and LDC governments’ perspective on the crisis, indicators of debt, net transfers, the major LDC debtors, the roles of World Bank and IMF lending and policies, proposals to resolve the debt crisis, and the distributional effects of the debt crisis and relief measures.

Definitions of External Debt and Debt Service

A country’s total external debt (EDT) includes the stock of debt owed to nonresident governments, businesses, and institutions and repayable in foreign currency, goods, or services. EDT includes both short-term debt, with a maturity of one year or less; long-term debt, with a maturity of more than one year; and the use of IMF credit, which denotes repurchase obligations to the IMF. External debt includes public and publicly guaranteed debt, as well as private debt (World Bank 1993i:ix, 158–159).

Debt service is the interest and principal payments due in a given year on long-term debt.

Origins of Debt Crises

Except for modest reductions in the early 1990s and early years of the 21st century, nominal LDC external debt increased from 1970 to 1999 (Table 16-1) for several reasons:

1.External debt accumulates with international balance on goods, services, and income deficits. LDC international deficits increased from a series of global

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shocks, including the 1973 to 1974 and 1979 to 1980 oil price rises (which reduced non-oil-producing LDCs’ terms of trade) and the recession of the industrialized countries, 1980–83, and continuing slow growth during the remainder of the 1980s (with sharply falling commodity prices, slowed export expansion, and increased OECD protectionism). Deficits increased throughout the 1990s until mid-1998 through 2003, as borrowers paid down debts (Chapter 15).

2.As indicated in Chapter 15, DCs relied more on private bank and other commercial lending, increasing its ratio to official aid from 1970 to the mid-1980s. Official development assistance (ODA) declined sharply in 1982–83 during the DCs’ recession, when LDC external debt grew at a faster rate from rising interest rates. After the mid-1980s, the trend for both commercial flows and official aid was downward or constant, at best, in real terms (Overseas Development Council 1982b:225–468; IMF 1988:96–109; and Chapter 15).

3.Like Iowa farmers and Pennsylvania small business people, LDCs reacted to the input price hikes of 1973 to 1975 by increasing their borrowing. The quadrupling of world oil prices in 1973 to 1974 poured tens of billions of petrodollars into the global banking system, which were “recycled” as loans to LDCs and U.S. farmers and business people at low rates of interest. They were lured by negative world real interest rates, the nominal rates of interest minus the inflation rate, −7 percent in 1973, −16 percent in 1974, and −5 percent in 1975. Many of these debts came due in the early 1980s when high nominal rates of interest, together with low inflation rates, resulted in high real interest rates (9–12 percent in 1982 to 1985) (Krueger 1987:169; Rahimibrougerdi 1988:6, 83; Cavanagh, Cheru, Collins, Duncan, and Dominic Ntube 1985:25). For many LDCs, the debt burden became a treadmill, with debt rollovers or rescheduling or, worse yet, defaults with higher interest rates or lack of access to credit.

The average interest rate for fixed-interest loans (generally subsidized or long term) rose from 4 percent (1970) to 6 percent (1981) to 7 percent (1986). From 1971 to 1981, interest rates on floating-interest loans (primarily from commercial sources) increased from 8 percent to 18 percent. The decrease in the average loan maturity from 20 years in 1970 to 16 years in 1986, as well as a reduction in the average grace period over the same period from 6 years to 5 years, aggravated the problem of debt service (World Bank 1988i:260–261), reducing the probability of eliminating the cycle of debt and contraction.

4.The inefficiency and poor national economic management indicated before in Nigeria, Zaire, and Ghana, as well as in Latin American military governments, in the 1970s, meant no increased capacity to facilitate the export surplus to service the foreign debt. Argentina’s substantial increase in public spending in the 1970s, financed by borrowing from abroad, increased external debt and reduced export capacity.

Chapter 19 indicates that the efficiency of public enterprise is potentially comparable to that of private enterprise, given a certain size firm, but that public firms are more likely to choose an excessive scale of operations, have easier access to state financing to mute bankruptcy, and more pressure to provide jobs and

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contracts to clients and relatives than private enterprises. Few LDCs achieve the high quality of economic management by the civil service and economic policy making insulated from political pressures achieved by Taiwan and South Korea (Chapter 3). In the early 1980s, before World Bank– and IMF-imposed reforms, government employment was high in LDCs, as Chapter 19 indicates.

To illustrate, in Nigeria, government expenditures as a percentage of GDP rose from 9 percent in 1962 to 44 percent in 1979 but fell to 17 percent from World Bank structural adjustment programs, such as the one in effect from 1986 to 1990, which emphasized privatization, market prices, and reduced government expenditures. Nigeria had centralized power during its 1967–70 civil war with the breakup of regions, and in the 1970s, as the oil boom enhanced the center’s fiscal strength. Expansion of the government’s share of the economy did little to increase political and administrative capacity, but it did increase incomes and jobs that political elites could distribute to their clients (Central Bank of Nigeria 1960– 80; Nigeria, Office of Statistics 1960–80; Ogbuagu 1983:241–266; Nafziger 1993:50). In the 1990s and early 20th century, smaller government and Bank– Fund programs only shifted the Nigerian elite’s opportunity for rent seeking; use of state power to divert oil and treasury funds to private use remained rampant.

5.The adjustment essential to export more than was imported and produce more than was spent required translating government spending cuts into foreign exchange earnings and competitive gains, usually necessitating reduced demand and wages, real currency depreciation, and increased unemployment. But when many other LDCs go through the same adjustment process, the benefit to any given LDC was less. In 1985, for example, the pressure on debtor countries to increase export revenues contributed to a glut in primary products and a collapse of their prices. In the 1990s, with increased participation by middle-income countries in DC-organized industrial value-added ladders, LDC competition entered another arena.

Mexico reduced real wages 40 percent, increased the unemployment rate, and depreciated the peso from 1980 to 1987 to increase its external competitiveness by 40 percent. Currency depreciation also raised the nominal interest rate essential to spur Mexicans to hold pesos rather than U.S. dollars. Few countries were willing to contract domestic employment and real wages to return the balance on goods and services account to equilibrium (World Bank 1985i:62–63; Dornbusch 1986:71–75; Sachs 1988:20).

6.The lack of coordination by leading DCs in exchange-rate and financial policies under the world’s post-1973 managed floating exchange-rate system (an international currency system where central banks intervene in the market to influence the price of foreign exchange) resulted in gyrating exchange rates and interest rates. Efforts to set target zones within which key DC exchange rates will float have only increased destabilizing capital movements and unstable exchange-rate changes when inevitably rates approach zone boundaries. This global instability increased external shocks and undermined long-run LDC planning (Khatkhate 1987:vii–xvi).

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By contrast, recent empirical evidence indicates that smoothing DC exchangerate fluctuations increases DC macroeconomic and external instability, whereas optimal fluctuations are fairly substantial, creating an environment that destabilizes the value of currencies that LDCs hold as international reserves.

With regard to DCs’ currencies, LDCs are damned if they’re stable and damned if they’re not. Developing countries incur costs from the fact that they rarely can undertake international transactions in their own currency.

7.When debts are denominated in U.S. dollars, their appreciation (increased value relative to other major currencies) during the early 1980s and much of the 1990s increased the local and nondollar currency cost of servicing such debts. Or, as in the late 1980s and early years of the 21st century, nondollar debts increased when measured in dollars that depreciate (reduce their value relative to other major currencies). For example, the dollar value of Indonesia’s 1985 debt to the Japanese, Y– 1250 billion, increased from $5 billion to $10 billion in 1988, as the dollar depreciated from Y– 250 = $1 to Y– 125 = $1. Volatility in leading reserve currencies, the U.S. dollar, euro, and Japanese yen, increases instability and costs in LDCs.

8.International lenders required LDC governments to guarantee private debt. When private borrowers defaulted, the state’s external debt service increased.

9.Overvalued domestic currencies and restrictions on international trade and payments dampened exports, induced imports, and encouraged capital flight from LDCs, exacerbating the current account deficit and external debt problems. One indicator of overvaluation, the black market exchange rate vis-a`-vis the official nominal exchange rate, appreciated in sub-Saharan Africa from 1.36 in 1971 to 1.53 in 1980 to 2.10 in 1983, before falling (often at World Bank/IMF insistence) to 1.38 in 1985, but increasing to 1.97 in 1990 before again declining to 1.41 in 1994 and 1.27 in 1999 (Aluko 2001:3). These exchange-rate distortions reduced export competitiveness while spurring applications for artificially cheap foreign capital and inputs (World Bank and UNDP 1989:12–17; Aluko 2001:3).

10.Substantial capital flight from foreign aid, loans, and investment and capital outflows of portfolio investors.

Capital Flight

Some bankers and economists feel it is futile to lend more funds to LDCs if a large portion flows back through capital flight. John T. Cuddington (1986) estimates that Mexico’s propensity to flee attributable to additional external borrowing, 1974 to 1984, was 0.31, meaning that 31 cents from a dollar lent by foreign creditors left the country through capital flight! The Organization for Economic Cooperation and Development suggests that the $70 billion capital flight from Latin America, 1982, was double the interest portion of the Latin debt-service payments for that year. Capital flight intensifies foreign exchange shortages and damages the collective interest of the wealthy classes that buy foreign assets. Reversing capital flight will not eliminate