Financial programming broadly involves the formulation of a set of economic policies that are reflected in the quantification of certain key domestic financial variables, including domestic credit expansion and public sector domestic financing. Taking into account the use of other policy instruments such as exchange rate and commercial policies, and under explicit assumptions on the short-term path of output and prices, the financial program aims at a specified balance of payments target, usually measured in terms of the change in net foreign assets of the monetary sector. The program may also include quantitative guidelines on medium-term foreign borrowing that are intended to prevent debt servicing difficulties over the medium term, particularly when substantial foreign borrowing already has occurred prior to the program. This aspect of external policies has not always been clearly integrated with the other policy instruments that are designed to attain an overall balance of payments objective. One reason for the lack of integration is that, although debt servicing problems frequently emerge as a consequence of inadequacies in domestic policies, external debt management is mainly concerned with medium-term effects on the economy whereas other policy instruments are geared to more immediate adjustments in the economy’s financial flows and balance of payments.
As a consequence of the different time frameworks for policy formulation, short-term financial policies may not be consistent with external debt management guidelines that would be appropriate in a medium-term context. These guidelines largely reflect an assessment of the availability and cost of foreign financing over the medium term, and impose a constraint on developments in the capital account of the balance of payments. This constraint needs to be taken into account in formulating financial policies designed to attain a given overall balance of payments target, in order for the short-term financial program to describe a sustainable path for the economy’s balance of payments and economic growth.
This paper presents an analytical framework to treat explicitly the impact of foreign borrowing on the domestic economy’s rate of growth, financial flows, and balance of payments. The framework is based on a relatively simple macroeconomic model (formalized in the Appendix) in which the impact of capital flows on the rate of growth in output can be analyzed in a multiperiod (i.e., medium-term) perspective. That impact is shown to depend on: (1) the level of net foreign borrowing; (2) the degree of substitution in the economy between foreign and domestic savings; and (3) the yield on the additional investment generated by the net capital inflow. The implications of growth in output for the balance of payments are shown to depend also on the degree to which additional resources are channeled to the external sector. The introduction of all these elements into the model allows for the determination of coordinated aggregate demand, exchange rate, and external debt management policies designed to achieve internal and external equilibrium both in the short run and over the medium term.
External debt management guidelines and associated balance of payments policies are discussed for those economies that are confronted with a potential constraint on the supply of external loan capital in the medium term. This is a rough approximation of conditions existing in economies where questions of external “creditworthiness” may have arisen. The paper abstracts from questions related to external direct investment.
Constraints on prospective developments in the capital account may narrow considerably the range of policy alternatives for a viable financial program. Formulation of such a program requires that current account developments be made compatible with the probable availability of foreign financing. Constraints on foreign financing should not be interpreted simply as limitations on aggregate availability during any period of time. The debtor will confront different terms for and availabilities of various types of loans and will have options concerning the composition of the loan “package” to be contracted. Under these circumstances, debt management guidelines help to ensure that the amount and maturity composition of new borrowing will yield the highest sustainable net resource transfer; they therefore define the upper limit on the current account deficit over the projection period.
A main implication of this paper is that prospective developments in the current account are very important for medium-term balance of payments management. Appropriate adjustment of the current account requires coordination of demand management and exchange rate policies in a medium-term framework to ensure financial stability, an adequate transfer of resources to the external sector, and avoidance of potential debt servicing difficulties over time. Another implication is that quantitative debt management guidelines help to ensure consistency between financing requirements and the availability of foreign financing over the medium term.
I. The Analytical Framework
Considerable interest has emerged in recent years with respect to the impact of domestic policies on the external accounts, within the framework of the monetary approach to the balance of payments.1 Capital flows have been incorporated into that analysis mainly in a short-term net flow context. The medium-term impact of such flows on economic growth and the balance of payments, as well as the eventual adjustment of the domestic economy to them, are not, however, incorporated explicitly. The adjustments in the short-term financial equilibrium of the economy in response to autonomous changes in the level of capital flows, as well as their impact on the growth pattern, are discussed in this section.
The general macroeconomic model presented in this section contains the essential elements to analyze the effect of changes in foreign debt and economic growth on the financial equilibrium of the economy over time. The model is basically that presented by Guitian elsewhere,2 which is adapted to cope with specific issues related to growth and debt. The model is described in detail in the Mathematical Appendix.
The model assumes (1) full employment, so that all internal adjustments in nominal incomes, other than those generated by the additional available resources, take the form of changes in prices; (2) the price of internationally traded goods is given to the borrowing economy (Exportables are consumed domestically or exported. Domestic production can be substituted for imports.); (3) capital flows are largely exogenous in the medium term, that is, they do not depend upon differences between domestic and external interest rates. The total amount of foreign funds is determined either by the authorities of the borrowing country or, alternatively, by the suppliers of those funds.3
Whenever the level of net capital flows4 increases exogenously from a prior equilibrium situation, such as when the public sector steps up its investment program, the economy adjusts to the higher level of available foreign resources. In the process of adjustment, the overall balance of payments outcome will depend upon the import component of the additional expenditure generated by such borrowing. When foreign resources are directly and entirely devoted to provide for additional imported goods, there will be no initial net impact on the overall balance of payments. The current account will deteriorate by the amount of the increase in imports, but this will be offset by the larger net capital inflow. Domestically, there will be no effect on prices as long as there are no bottlenecks with respect to the absorption of the additional imported goods. In the more likely event that foreign loans are used, at least in part, to finance expenditures on domestic commodities, the effect will be considerably different.5 In this case, the additional foreign financial flows will initially result in higher foreign reserves and, with a passive monetary policy, in concurrent increases in domestic monetary liabilities. The increase in monetary liabilities eventually will result in an increase in the level of aggregate expenditure.6 The increase in aggregate expenditure will be reflected domestically in higher prices and in higher nominal income, and will leak partly into the balance of payments through additional imports, thus widening the current account deficit.
When the borrowing country pegs its exchange rate, the adjustment will be through an increase in its domestic prices, owing to the increased supply of domestic liquidity and a larger current account deficit. When the exchange rate floats freely, the capital flows will induce an appreciation of the domestic currency, following the increase in the supply of foreign exchange. In both cases, the resulting increase in the relative price of nontraded goods will cause a shift of resources from the traded goods sector, and will tend to produce further deterioration in the current account. If the net capital inflows are not sustained, the relative price changes will be reversed eventually. With a fixed exchange rate, the current account deficit cannot be fully financed and reserves will decline. This will be corrected only if prices and/or domestic activity decline. In the case of flexible rates, the exchange rate will depreciate.
In addition to their effects on relative prices and the current account, the inflow of resources (financed) from abroad is a supplement to domestic resources, and thus allows for a higher level of investment and/or consumption. To the extent the additional resources result in an increase in the rate of capital accumulation,7 the growth rate of potential output will be higher over time. Generally, foreign resources will be directed only in part to increased capital formation. Even if the net resource transfer8 is totally associated with investment expenditure, the increase in total investment in the economy may well be less than the inflow itself. If the foreign resources are channeled to the private sector, this may result in a reduction in domestic interest rates, and thus in a decline in domestic private savings as a proportion of national income. If so, the net increase in investment will almost certainly be smaller than the net resource transfer to the country. Whenever the additional foreign resources are obtained by the public sector and used to finance projects that would, in any case, have been undertaken, the increase in net investment may also be smaller, to the extent that domestic resources thus released are used to finance current expenditure.
The greater the proportion of foreign financing that results in net additional investment, the greater will be the increase in potential gross domestic product (GDP)—that is, the greater the increase in total resources available for domestic use plus factor (interest) payments abroad. The increase in the resource availability for domestic use—the potential increment in gross national product—will be positive and will increase over time as long as the domestic yield of the foreign resources exceeds the effective interest rate on the loans, assuming costs and benefits are properly measured.9 The outcome with respect to the increase in available output will further depend upon whether income forgone to repay the debt will reduce consumption or savings, an outcome largely dependent upon the interest rate and government expenditure policy. If repayments are financed from reduced savings, the rate of capital accumulation, and consequently future growth, will be lower than otherwise.
In this section, attention is focused on the interaction among growth, the balance of payments, and the accumulation of debt. Foreign borrowing requirements will depend upon the current account outcome resulting from the growth and the composition of output, particularly its division between traded and nontraded goods. In this context, external debt management is of crucial importance. In a world of perfect capital mobility, with no significant constraints on borrowers’ access to foreign capital, the amount of net borrowing would be determined by possible yield differentials, adjusted for the degree of risk as perceived by creditors; but the level and composition of debt would be determined by demand in the borrowing country.
In the absence of any constraints on foreign borrowing, a given set of targets for growth and composition of output imply a certain current account outcome. For example, a decision to increase the level of investment would require a higher level of imports of capital goods for the new projects, as well as the complementary raw materials and intermediate goods for the new production. These imports will be offset only in part by increases in the production of traded goods (exportables and import substitutes). The projected current account deficit (including interest payments), taken in conjunction with the amortization of outstanding external debt, will give an indication of the size of the foreign exchange gap to be covered initially by foreign borrowing and/or use of international reserves, assuming given exchange and interest rates. In addition, the debt service in successive years arising from each year’s new disbursements must be taken into account in order to have an indication of the resulting gross borrowing requirements over time. The foregoing provides a simple, but consistent, framework for the analysis of external debt in the context of the balance of payments.
Table 1 provides an illustration of the mechanics for such an exercise. A targeted increase in the growth rate of GDP from 5 per cent to 6 per cent per year, linked to an increase in investment, is assumed to start in period 2. In the table, a 40 per cent increase in the level of investment is assumed; imports of capital goods increase sharply in year 2. This results in the rise in the growth rate of GDP, which eventually leads to higher import requirements and a more rapid rate of growth of exports, as resources are directed to the external sector. The table also indicates that attainment of the growth targets requires a rapid increase in gross capital inflows over time. As a consequence of the relatively large net capital inflow, external debt accumulates rapidly. An increase in the rate of growth of GDP of 1 percentage point per year is accompanied by a twofold increase in gross flows and a level of debt almost three times higher in the sixth year than in the first year. These results depend mainly upon the assumptions about the performance of exports and/or, import substituting activities and the import component of investment. The approach underlying Table 1 emphasizes the “need” for funds, or more simply, the demand side for a given set of targets in the absence of external constraints on foreign financing.
|1. Exports of goods and non-factor services1||200||210||223||236||250||265||281|
|2. Imports of goods and nonfactor services||−200||−245||−259||−275||−291||−310||−327|
|3. Current account|
|(net of interest payments)||—||−35||−36||−39||−41||−45||−46|
|4. Debt service payments on outstanding debt in period 0||−41||−37||−34||−30||−27||−24||−21|
|5. Debt service payments on debt contracted during period 4||—||−3||−9||−20||−36||−61||−71|
|6. Total debt service payments||−41||−40||−43||−50||−63||−85||−92|
|7. Total required gross inflows 5 (3+6) (plus equals inflow)||41||75||79||89||104||130||138|
|(Rate of growth)||(0.05)||(0.05)||(0.06)||(0.06)||(0.06)||(0.06)||(0.06)|
|External debt outstanding beginning of period||200||216||268||325||389||461||550|
|Net capital flows||16||52||57||54||72||89||88|
|Net resource transfer||—||35||36||39||41||45||46|
It is likely that a borrowing country will not have access to all its required financing; the supply constraint will have to be incorporated in the model to determine the feasibility of the targets established. Such supply constraint may eventually necessitate a reduction in the prospective current account deficits through corrective demand management and/or exchange rate policies. A reduction in the current account deficit may only be consistent with a lower growth rate in GDP than was originally targeted. It can be argued that inflows of borrowed funds over time are determined by portfolio considerations of the lenders. Portfolio balance could result in limitations on capital inflows that kept them below the amounts that would be considered optimal by the borrowers for given interest rates. Lenders may be influenced not only by yield considerations but, in individual country situations, also by the extent of their holdings of the debtor country’s obligations.10
The existence of supply constraints (limitations) on the inflow of foreign loans may create a divergence between the prospective net capital requirements of the borrowing country—given its existing economic policies—and its likely access to new loans. The loan supply limitations may be of different forms for various categories of loans. In the case of international banking credits, there may be exposure limits, defined in terms of maximum outstanding debts of a particular country to individual banks. In the case of governmental aid agencies and development finance institutions, the limitations may be defined in terms of annual (gross) loan authorizations. Export credit/guarantee agencies—generally public or quasi-public entities—frequently establish various types of lending limits to individual countries depending on the circumstances, including ceilings on exposure, on annual commitment levels, or even in terms of the maximum size of individual loan transactions. Although this is perhaps less true in the case of governmental aid loans, such supply limitations tend to be linked to the “creditworthiness” of the particular borrowing country, which is related to its economic performance and prospects, its current set of economic policies, and its past experience with management of foreign indebtedness. Where such supply limitations provide the effective constraint on foreign resource availability, the demand for foreign funds has to adjust accordingly. A growth target that was sustainable in the absence of a supply constraint will be feasible only if domestic policies can be adjusted to eliminate the possible excess demand for foreign funds.
The impact of adjustment measures is exemplified in Table 2. It is assumed that, owing to limitations on the availability of foreign financing, external debt outstanding can increase by no more than an annual rate of 10 per cent, compared with 19 per cent in the unrestricted case (shown in Table 1). In this example, credit and fiscal policies are used as corrective instruments to adjust the imbalance between expenditure and income, in order to bring the country’s current account deficits into line with the lower external resource availability. It is further assumed that the adjustments affect the level of investment, and therefore reduce the expected annual rate of growth of GDP from 6 per cent to 5.1 per cent.11 Imports slow down in comparison with the previous case, while exports continue to increase at the same rate as GDP. A decline of 2.0 percentage points in the annual rate of growth in imports reduces substantially the need for additional foreign funds. In six years, gross flows increase by 80 per cent, compared with 236 per cent in the previous case; the level of debt outstanding is less than one and a half times higher than that of the initial period, compared with a debt nearly three times higher than in the previous case.
|1. Exports of goods and nonfactor services2||200||210||221||232||244||256||270|
|2. Imports of goods and nonfactor services||−200||−215||−225||−237||−249||−262||−279|
|Capital goods 3||(100)||(110)||(115)||(121)||(127)||(134)||(144)|
|3. Current account (net of interest payments)||—||−5||−4||−5||−5||−6||−9|
|4. Debt service payments on outstanding debt in period 0||−41||−37||−34||−30||−27||−24||−21|
|5. Debt service payments on debt contracted during period5||—||−3||−7||−16||−26||−35||−44|
|6. Total debt service payments||41||−40||−41||−46||−53||−59||−65|
|7. Total available gross flows (3+6) (plus equals inflow)||41||45||45||51||58||65||74|
|(Rate of growth)||(0.05)||(0.051)||(0.051)||(0.051)||(0.051)||(0.051)||(0.051)|
|External debt outstanding beginning of period||200||216||238||261||287||316||347|
|Net capital flows||16||22||23||26||29||31||36|
|Net resource transfer||—||5||4||5||5||6||9|
It is in the context of the necessary adjustments in the current account that the link between external debt management and other policies becomes apparent. Management of external debt should aim at providing the maximum possible net resource transfer that can be sustained over time, while other policies must provide for a sustainable current account outcome consistent with access to foreign borrowing over the medium term.12 The capital account itself thus becomes a constraint in balance of payments management, either because of exogenously limited amounts of foreign loans or self-imposed limitations on contractual debt.
II. The Role of Debt Management Guidelines
Debt management guidelines, in the context of a financial program, broadly describe a borrowing policy that should provide a country with the maximum sustainable net resource transfer over the medium term. The feasibility of that borrowing policy can be viewed either in terms of the demand of the borrowing country or the supply provided by the creditors with foreign financial resources to lend. If, over the medium term, the potential supply of foreign resources is sufficiently large, borrowing policy should reflect the capacity of the economy to efficiently utilize additional foreign resources in any given year. The amount of foreign resources devoted to increased domestic investment would be determined by the financing requirements of the additional projects whose effective yields exceeded the interest rate on borrowed funds. In particular, new borrowing in the public sector should be subject to guidelines in order to ensure that outcome. The pursuit of a realistic exchange rate and interest rate, plus appropriate pricing policies, would provide the basic framework for making such rational investment decisions in the private sector.
In many cases, the amount of foreign loan resources available to the borrowing country—long-term government assistance, international banking credits, supplier credits, etc.—will be limited from the supply side. Although the terms for each type of debt are, in general, beyond the control of the borrowing country, it does have an option with respect to the composition of the loan package to be arranged. In the presence of a possible medium-term supply constraint on overall disbursements, the most rational policy would be one aimed at obtaining the best possible average terms (e.g., interest, maturity, and grace period) in order to attain the maximum sustainable net resource transfer.13 Debt management guidelines formulated as limitations on the amounts of new loans in various maturity ranges will ensure that the terms and amounts of new borrowing will be in line with the available foreign funds in the medium term, and that the loan composition yields the maximum amount of resources that can be transferred to the country on a sustainable basis.
The lack of complete information about the nature of the supply constraints and the availability over time of the alternative types of loans pose important practical difficulties for the establishment of debt management guidelines. It is not simple to define the possible level and terms of new commitments that can be sustained. Such information can, however, be roughly projected on the basis of the past experience of the particular borrowing country.14 Once the possible availability of various types of loans has been assessed, the capital account constraint can be defined and a feasible target for the current account can be determined.
Whenever new loans are contracted for on terms that are significantly less favorable than those established by the debt guidelines, the medium-term objectives set forth may be in jeopardy. If new loans are contracted to provide for the same annual level of disbursements as would be the case with the loan package described by the guidelines, the net resource transfer will be smaller. Alternatively, if the net resource transfer is to be sustained, this will require a higher level of disbursements.15 This is illustrated in Table 3, where the various debt-related flows for three alternative loan packages are presented for the periods under consideration in Tables 1 and 2. Alternative 1 is the same as that presented in Table 2, under the assumption that the new borrowing follows the established debt guidelines. Alternative 2 is derived under the assumption that the level of disbursements is the same as in Alternative 1, but the final maturity of the new loans is reduced from an average of ten years to six, while the grace period is reduced from an average of two years to one. Alternative 3 consists of a loan package that provides for the same net resource transfer as Alternative 1; however, new loans are arranged on the shorter terms established for Alternative 2.
|Alternative Loan Packages||0||1||2||3||4||5||6|
|Alternative 1.||Loan package according to debt ceilings1|
|Net capital flows||16||22||23||26||29||31||36|
|Net resource transfer||—||5||4||5||5||6||9|
|Debt outstanding beginning of period||200||216||238||261||287||316||347|
|Alternative 2.||Loan package with maintenance of disbursement level2|
|Net capital flows||16||22||15||14||14||12||11|
|Net resource transfer||—||5||−4||−6||−7||−10||−12|
|Debt outstanding beginning of period||200||216||238||253||267||281||291|
|Alternative 3.||Loan package with maintenance of net resource transfer3|
|Net capital flows||16||22||23||26||29||31||36|
|Net resource transfer||—||5||4||5||5||6||9|
|Debt outstanding beginning of period||200||216||238||261||287||316||347|
Alternative 2 shows that, for a constant level of disbursements, a significantly smaller net capital inflow occurs over the period under analysis; the net resource transfer available becomes negative over the period. Therefore, the current account has to be adjusted to the smaller capital flows. In Alternative 3, the level of disbursements has to be significantly larger than in Alternative 1 to maintain the net capital inflow and resource transfer at the levels of Alternative 1. By period 6, the level of disbursements in Alternative 3 is more than 50 per cent higher than that required in Alternative 1. The average annual rate of increase in disbursements, which is about 10 per cent under Alternative 1, increases to more than 20 per cent under Alternative 3 in order to attain the same transfer of real resources. This may imply an annual level of commitments that is not sustainable over the medium term owing to constraints on the availability of foreign financing.
III. The Adjustment of the Economy over Time
When the utilization of foreign resources leads the economy to higher investment and growth paths, the current account will reflect both the resulting higher level of imports and the allocation of additional resources to exports and import substitutes. Whenever the original current account deficit, together with the scheduled amortization payments on existing debt, exceeds the available gross foreign financing, it becomes necessary to adopt measures to reduce the current account deficit. One alternative among various adjustment policies is to reduce aggregate expenditure by means of restrictive fiscal and monetary policies, thereby curtailing domestic demand for traded goods. These policies may initially result in a decline in domestic activity, and eventually may result in a decline in the relative price of domestic goods, creating incentives to transfer resources to the external sector and to increase the level of economic activity. Another method would be to change relative prices in order to shift additional resources to the traded goods sector through exchange rate action supported by complementary domestic credit policies to facilitate the shift in resources. The latter course of action may have to be taken if the level of expenditure associated with the higher growth target has resulted in domestic price pressures and cost-price distortions. In both cases it is clear that improvement in the current account over the medium term requires a change in the relative prices of traded and nontraded goods.
The degree of adjustment in the current account will depend heavily on the performance of the external sector. If the investment effort generated by new capital inflows is heavily oriented toward the promotion of exportables or import substitutes, there will be a relatively rapid reduction in the potential foreign resource gap that needs to be financed or corrected. If the new investment is directed mostly toward nontraded goods, the current account will tend to deteriorate more (or improve less) for any given exchange rate than when the new resources are geared to the external sector. In general, the current account will show a relative deterioration because of increased demand for imports and increased domestic demand for exportables linked to the growth of GDP16 and the additional inputs required for new projects.
Exchange rate adjustments, by correcting distortions in relative prices, help to reallocate resources between the international and domestic sectors of the economy. Assuming some mobility of resources to the traded goods sector, exchange rate depreciation can be a powerful instrument in improving the current account—even in the short term—but only if the depreciation is accompanied by appropriate domestic policies that ensure a reduction in the level of expenditure relative to income. The nature of the complementary policy adjustments will depend upon the objectives established for the level of economic activity and the balance of payments. Over time, the production of exports and import substitutes will respond to the devaluation when internal policies are followed that facilitate resource movements to the external sector. The lasting success of a devaluation in attaining balance of payments objectives will depend crucially on a continuation of demand management policies that maintain an appropriate relationship between aggregate expenditure and output. Otherwise, the potential effects of the devaluation may be dissipated by the pressures of increased demand and rising domestic prices.
Current account adjustments can also be brought about through adjustments in fiscal and credit policies. In the area of fiscal policy, modifications in taxation or expenditure policies can be used for this purpose. This type of policy will work to bring about an improvement in the current account only if aggregate expenditure is reduced relative to aggregate income. The nature of the fiscal effort is crucial in determining its impact on the balance of payments.17 Whenever the adjustment in public sector performance—that is, an increase in public sector revenues and/or a decrease in expenditure—directly affects the level of imports or exports, fiscal policy will be a powerful instrument for achieving an improvement in the current account. Otherwise, the improvement in the public sector deficit will affect the balance of payments outcome indirectly, as a result of a reduction in overall expenditure and the consequent decline in domestic prices or in the level of economic activity—both of which will have an adverse impact on the current account.18 In addition to the overall effect of increased taxation or reduced expenditure on the current account, fiscal policy may be designed to provide the government with the resources to repay foreign loans in those cases where the direct benefits of the various investment projects are obtained outside the public sector.
Credit policies can be pursued independently in order to attain current account adjustments. Restrictive credit policies with no recourse to exchange rate or fiscal policies will directly influence the level of aggregate expenditure, as the economy adjusts to provide for the demand for monetary assets.19 A reduction in the rate of increase in domestic credit below the financing requirements of the existing level of activity and/or prices will, in general, generate an excess demand for those assets that will be reflected in a decline in nominal income and an improvement in the balance of payments. Unless capital is highly mobile in response to interest rate differentials, most of the improvement in the balance of payments will be reflected in the current account. The improvement in the current account, as a consequence of a lower growth rate of domestic credit, will accommodate the constraint on the capital account. Nonetheless, this improvement may well result in a decline in economic activity (and consequently in the growth target) unless either (1) all of the adjustments occur in the traded goods sector or (2) domestic prices adjust downward at the lower level of expenditure.
Credit policy should be viewed more generally, in the context of a set of financial policies (including exchange rate and fiscal policies) that may be used to achieve balance of payments equilibrium and financial stability. The exchange rate will be a powerful instrument for correction of an external imbalance because of its direct impact on the relative prices of traded goods and its consequent effect on the current account. If this desired change in relative prices is to be sustained, the exchange rate action must be accompanied by a complementary credit policy. The increase in domestic liquidity should be limited to the amount necessary to accommodate the increased demand generated by (1) the growth in GDP and (2) the increase in the price level directly generated by the change in the exchange rate. The impact on domestic liquidity of any desired change in net international reserves must also be taken into account in the formulation of the domestic credit program.20
If the credit policy pursued is not in line with exchange rate and desired domestic price developments and with the liquidity needs of the economy, it will result in a disequilibrium in the money market; this will be reflected in unwanted changes in prices (or in the level of economic activity) and in an unwanted change in international reserves. An expansion in credit beyond the requirements of growth and equilibrium in the balance of payments (adjusted for any desired change in foreign reserves) will generate inflationary pressures. With a fixed exchange rate, direct increases in imports, declines in exports, and a reduction in the relative price of traded goods will occur, with a consequent deterioration in the balance of payments. An expansion in domestic credit below the financial requirements of the economy may result in an improvement in both the balance of payments and the current account, but may be accompanied by a decline in domestic prices and/or the level of economic activity. When the country follows a flexible exchange rate policy, the rate, domestic prices, and economic activity will adjust in line with the shortfall in domestic credit, to provide for domestic equilibrium. The distribution of the impact of credit on the balance of payments, prices, and real output clearly will depend on the openness of the economy—that is, the relative size of the external sector and the degree of (quantitative) restrictiveness imposed on external transactions.
In summary, the possible constraint on foreign financial flows (gross or net) requires that available policy instruments be coordinated to provide for the achievement of the various economic goals, including equilibrium in the balance of payments. There may be a combination of exchange rate, commercial, credit, and fiscal policies. All instruments can be used simultaneously, with direct effects on the current account owing to movements in the exchange rate, the improvement of the public sector savings performance, and the impact of appropriate credit policies. These policies will be reinforced by external debt management policies that help to ensure attainment of the maximum sustainable net resource transfer available to the country.
|E||=||Total private expenditure|
|e||=||Real expenditure in domestic commodities|
|ẏ||=||Rate of growth of income|
|B||=||Balance of payments|
|BT||=||Balance of trade|
|X′||=||Ratio of export earnings to total reserves|
|X*||=||Autonomous change in exports|
|Xd||=||Domestic demand for exportables|
|m*||=||Autonomous change in imports|
|F||=||Net resource transfer|
|Md||=||Demand for money|
|Ms||=||Supply of money|
|p||=||Price of domestic commodities|
|T/p||=||Real exchange rate|
|r||=||Interest rate, domestic (rate of return on capital)|
|K||=||Stock of capital (all-inclusive)|
|s′||=||Marginal savings ratio|
|s||=||Marginal savings ratio out of foreign funds|
|i||=||Average rate of interest on external debt|
|g*||=||Autonomous rate of growth of GDP|
|AL||=||Participation of labor in GDP|
|TC||=||Autonomous changes in GDP (technology, etc.)|
|D||=||External debt outstanding|
|NF||=||Net capital flows|
|u||=||Rate of growth of debt|
I. the macroeconomic model
The macroeconomic model will be defined by the following relationships, at any point in time:
|1.||E = p·e + T·px·Xd + T·pm·m||Expenditure|
|2.||p* = Z1p + Z2T·px + Z3T·pm||Prices (Z1, Z2, and Z3 are constants)|
|3.||Y = E + G + BT||Income|
|4.||Y = p*y; yt = yt-1(1 + ẏ)||Real income in period t|
|5.||(P·e)/p* = f (Y/p*; T/p; pm; px; r)||Demand for domestic goods|
|6.||(T·pm·m)/p* = (y/p*; T/p; pm; px; r) + m*||Demand for imports|
|7.||G = G0||Government deficit|
|8.||px·X = X(Y/p*; T/p; pm; px; r) + X*||Real supply of exports|
|9.||B = px·X – pm·m + F||Balance of payments|
|10.||BT = px·X – pm·m||Balance of trade|
|11.||F = F0||Capital flows|
|12.||pm = pm0||Import prices|
|13.||px = px0||Export prices|
|14.||T = T0||Exchange rate|
|15.||Md = p*·L(Y/p*, r)||Demand for money|
|16.||Ms = C + T·R||Supply of money|
|18.||Md = Ms||Equilibrium in the monetary sector|
|19.||C = C0||Domestic credit|
Exogenously determined or policy-determined variables are identified by a “0” subscript.
II. equilibrium in the various markets
1. Goods and services
(dy/y - ẏ)(y/e - Ney) = (NeT + NXT·X/e)(u·dT/T - dp/p) + Ner·dr/r + G/E·dG/G21
where, for example, Nwz is the elasticity of variable w in terms of z.
NeT + (NXT)(x/e) ≧ 0
NeT: Elasticity of demand of domestic commodities in terms of the exchange rate (> 0)
NXT: Elasticity of supply of exportables (> 0)
y/e > Ney > 0; Ner < 0
g: Proportion of government deficit (expenditure) spent on domestic goods Under the assumption of full employment, the actual change in income is dy/y = ẏ; it is determined exogenously by the process of investment and the increase in other resources (Appendix, Section III.1).
2. Money market
b·dC/C + (1 – b) dR/R = a1 dp/p + (b – a1) dT/T + a2 dpx/px + a3 dpm/pm + NMy dy/y +NMr dr/r
where b in the coefficient of dT/T reflects the impact of revaluation of reserves; the third and fourth terms reflect the increase in the demand for money resulting from foreign inflation; and a1, a2, and a3 are constants.
b = C/M; (1 - b) = TR/M
a1 = Z1p/p*; a2 = Z2pxT/p*; a3 = Z3pmT/p*
a1 + a2 + a3 = 1
NMy > 0; NMr ≦ 0
3. Balance of payments
dR/R = (pr·X/R) [(EXT – NmT) (dT/T – dp/p) – NBy dy/y – NBr dr/r] + (1 - m′) dF/R – (Nmpm + 1) (px·X/R) dpm/pm + (1 + EXpx)(px·X/R)dpx/px – (1 – g)G/E·dG/G + (px·X/R) dx′/x
|m′||=||Marginal propensity to import from capital flows|
|EXT||=||Elasticity of supply of exports (> 0)|
|NmT||=||Elasticity of demand for imports (< 0)|
|NBy||=||Income elasticity of demand for traded goods (> 0)|
|NBr||=||Interest rate elasticity of demand for traded goods (< 0)|
|Nmpm||=||NmT; NXpx = NXT, for constant international prices|
|dx′/X||=||(dX* – dm*)/X = Autonomous improvement in the current account22|
4. Overall macroeconomic equilibrium
Equilibrium can be attained for dp/p; dr/r; dR/R as
where X′ = (X·px)/R
The nature of this system permits inclusion of other independent variables, as well as the substitution of the above-mentioned endogenous variables, for others in the system (i.e., dy/y, dT/T, dC/C) for given objectives in reserves, prices, and interest rates.23
In particular, if the assumption of perfect capital mobility is introduced, the interest rate will be determined exogenously, and the net capital flows become the dependent variable that is affected by domestic demand policies.24
III. growth, foreign financing, and domestic policies
1. Growth and foreign indebtedness
In order to establish the equilibrium path of the economy in the medium term when there is restricted access to foreign capital flows, the relationship among growth of GDP, investment, and foreign indebtedness has to be analyzed more closely. Once the likely pattern of capital flows over time, and their impact on the size of GDP and its composition, are determined, the necessary adjustments in the exchange rate, and other policies to provide for a consistent current account outcome, can be derived. (See Appendix, Section III.2.)
In order to establish the link with foreign funds, growth in GDP may be defined within the context of a (neoclassical) production function of the form:
where K and L are homogeneous and f is linear and homogeneous.
Changes in GDP over time will be
where “•” denotes rate of change over time; for example,
and I = dK/dt
dy/dK = r, rate of return on capital 25
dy/dL = W, wage rate, and AL = LW/y
Correspondingly, growth will be defined as
The investment function is of the form
where I0 is autonomous investment27
The autonomous rate of growth is
is the rate of growth of GDP in any given year.
From (5), it can be seen that the contribution of foreign resources to growth in any given year will depend decisively upon the net resource transfer (NF – iD). A positive net resource transfer will lead to an increase in the rate of growth, while a negative net resource transfer will result in a declining rate. As
The net resource transfer will be positive if the rate of growth of debt (u) is higher than the average interest rate paid on debt outstanding (i); it will be negative in the opposite case.
Previous accumulation of external liabilities will be reflected in a higher level of GDP, and will influence g* if the average savings ratio increases with income. In addition, the rate of growth will depend upon what proportion of the foreign resources obtained is used for additional investment,28 upon how much is consumed, and upon the yield on investment (r).29
In the particular case where the terms of new borrowing (interest rate, grace period, and maturity) are given, it can be shown that, over time, the rate of growth of debt will be equal to the rate of growth of disbursements.30 Consequently, if this rate of growth is higher than the average interest rate, the net resource transfer will be positive. In order to achieve a given net resource transfer higher than that provided for the given terms and the rate of growth of debt, the only alternative will be to increase gross flows at a faster rate (compared with the prevailing rate), although over time this will result in a higher rate of growth in debt and may be out of line with increases in other variables, such as exports or GDP. Alternatively, the terms will have to be improved; however, this may not be feasible if proper consideration is given to the availability of financing.
2. Coordination of external debt management with domestic credit and exchange rate policies
Once the growth of GDP, the “autonomous” improvement in the current account resulting from growth, and the pattern of net resource transfer are established, the necessary adjustments in domestic policies to provide for equilibrium in the economy can be readily obtained. The capital flow, the rates of growth of GDP, and the autonomous improvement in the current account can be introduced as exogenous variables. Assuming certain targets for price increases and reserves, the required adjustments in the exchange rate and domestic credit may be obtained.
If dp/p = dR/R = 0 31 and, for simplicity, NMr = NBr = 0, the required changes in credit, the exchange rate, and the interest rate will be
where the asterisk denotes the amount of change needed in the variables to obtain required changes.
If all available foreign funds are used directly for additional imports (m′ = 1), the effect on the exchange rate will be explained only by the changes in GDP and production of traded goods. If the value of m′ < 1, then the required appreciation of the exchange rate will be greater. In any case, the numerator of the expression for dT/T reflects the initial effects on the current account, the growth of GDP, and capital movements. The adjustment in domestic credit takes into account increases in GDP and the exchange rate.32
Although the model assumes instantaneous adjustment in the balance of payments, a lag between the moment of change in the exchange rate and its effect on traded goods may exist. Consequently, the assumption of unchanged reserves may be relaxed for the initial periods to allow for declines in net foreign assets. In the medium term, the condition may be reversed to allow for increases in reserves. “Autonomous” domestic price changes may be readily included in the expression, so that the exchange rate and domestic credit may be adjusted accordingly.
The existence of constraints on the net resource transfer over time, as a direct consequence of the limitation of new borrowing, will provide a required pattern of adjustment in exchange rate and other policies. If the targeted growth rate of GDP and the expected composition of output are not consistent with the available net resource transfer over time, then dy/y, dx′/X, or dT/T will have to adjust. The likelihood of possible adjustments in the last two will strongly influence the need to revise the growth target for the economy.
If the policies pursued are not in line with the stated objectives on prices and reserves, financial equilibrium may not be achieved. This is reflected in equations (10) and (11), where changes in prices and reserves are presented as functions of the discrepancies between actual and equilibrium values for credit and the exchange rate, as obtained in equations (7) and (8).
where for NMr = NBr = 0;33
Δ pC = -(b Ner)/ Δ > 0
Δ pT = -(b Ner X′) (EXT – NmT)/ Δ > 0
Δ RC = (b Ner)/ Δ < 0
Δ RT = -(b Ner X′) (EXT - NmT)/ Δ > 0
An expansion of credit beyond the equilibrium value will result in increases in prices and a deterioration in the balance of payments.34 An adjustment in the exchange rate larger than is indicated by dT* will help to reduce the balance of payments disequilibrium, but may eventually result in even higher prices for domestic commodities. A smaller than indicated change in the exchange rate may reduce the pressure on domestic prices, but aggravate the loss of reserves.35
3. Coordination of external debt and fiscal policies
When dT/T = dp/p = 0 and government expenditure (or the deficit) adjusts, the equilibrium value for changes in government expenditure under the assumption that NMr = NBr = 0 will be 36
Consequently, a contraction of expenditure is required by the government to offset increases in GDP in order to provide for equilibrium in the balance of payments. Increases in exports and net capital flows can be offset by increased levels of government activity. Changes in dG and dC not in accordance with the values (12) and (13) will result in unwanted changes in prices (or economic activity) and reserves, along the lines presented in the previous section.
IV. increases in import prices and foreign financing
Whenever foreign prices increase, their impact will depend upon (1) the elasticity of demand for imports, (2) the foreign financing, and (3) the monetary financing of domestic price increases.
The effect of changes in foreign prices on domestic prices and reserves can be derived from the Appendix, Section II.4.
dp/p = Ner [(1 - b) (Nmpm + 1) (px·X/R) + a3] / Δ
under the assumption of NMr = NBr = 0
If /Nmpm/ > 1, the change is unclear as foreign expenditures decline, and if /Nmpm/ < 1, dp/p will be negative.
The change in reserves owing to the increase in foreign prices will be
dR/R = Ner [a1 (Nmpm + 1) (px·X/R) – a3 (px·X/R) (EXT – NmT)] / Δ
if /Nmpm/ > 1, reserves increase while if /Nmpm/ <1, the sign of the change is indeterminate. If the increase in foreign prices is completely financed by foreign net capital flows, the flows will amount to
dF/R = [Nmpm + 1] (X·px/R) (dpm/pm), which is equal to the direct impact of the price increase. The change in prices and reserves will be
dp/p = a3Ner/ Δ < 0
dR/R = a3 (px·X/R)(EXT - NmT) (Ner / Δ >0
Domestic prices will decline and reserves will improve because of the restrictive effect of foreign price increases on real cash balances. If domestic credit is allowed to finance the increase in foreign prices, no change in reserves or prices will take place.
dC/C = a3·dpm/pm
dp/p = dR/R = 0
Under these circumstances, unchanged levels of activity with equilibrium in the balance of payments can be achieved only if sufficient foreign funds are available. If the available net flow is reduced over time, adjustments will be required in the exchange rate, government spending, and economic activity.
Almonacid, Ruben, and ManuelGuitian, “The Optimal Rate of Devaluation,” in The Economics of Common Currencies, ed. by Harry G.Johnson and Alexander K.Swoboda (London, 1973), pp. 281–97.
Dhonte, Pierre, “Describing External Debt Situations: A Roll-Over Approach,” Staff Papers, Vol. 22 (March1975), pp. 159–86.
Fontaine, Ernesto, and MarceloSelowsky, “Algunas Consideraciones Sobre el Financiamiento Externo en un Contexto de Costos y Beneficios,” in Cuadernos de Economía (Catholic University of Chile, 1973), pp. 313–43.
Galbis, Vicente, “Monetary and Exchange Rate Policies in a Small Open Economy,” Staff Papers, Vol. 22 (July1975), pp. 313–43.
Guitian, Manuel, “Credit Versus Money as an Instrument of Control,” Staff Papers, Vol. 20 (November1973), pp. 785–800.
Hahn, F. H., and R. C. O.Matthews, “The Theory of Economic Growth: A Survey,” in Surveys of Economic Theory, Vol. 2 (New York, 1967), pp. 1–124.
Ishiyama, Yoshihide, “A General-Equilibrium Flow Analysis of an Open Economy” (unpublished, International Monetary Fund, July11, 1975).
Johnson, Harry G., “The Monetary Approach to Balance-of-Payments Theory,” Journal of Financial and Quantitative Analysis, Vol. 7 (March1972), pp. 1555–72.
McKinnon, Ronald I., “Portfolio Balance and International Payments Adjustment,” in Monetary Problems of the International Economy, ed. by Robert A.Mundell and Alexander K.Swoboda (Chicago, 1969), pp. 199–234.
Metzler, Lloyd A., “The Process of International Adjustment Under Conditions of Full Employment: A Keynesian View,” in Readings in International Economics, ed. by Harry G.Johnson and Richard E.Caves (Homewood, Illinois, 1968), pp. 465–86.
Mundell, Robert A. (1968), International Economics (New York, 1968).
Mundell, Robert A. (1971), Monetary Theory: Inflation, Interest and Growth in the World Economy (Pacific Palisades, California, 1971).
Ohlin, Goran,Aid and Indebtedness: The Relations Between Aid Requirements, Terms of Assistance and Indebtedness of Developing Countries, Organization for Economic Cooperation and Development, Development Centre (Paris, 1966).
Organization of American States, Official External Financing in Latin American Development Strategy: Implications for the Seventies (Washington, 1973).
Otani, Ichiro, and YungChul Park, “A Monetary Model of the Korean Economy,” Staff Papers, Vol. 23 (March1976), pp. 164–99.
Mr. Loser, economist in the External Finance Division of the Exchange and Trade Relations Department, is a graduate of Cuyo University in Argentina and received his doctorate from the University of Chicago. Before joining the Fund, he was a professor of international economics at Cuyo University.
An earlier version of this paper was presented to a meeting of the Central Bank Technicians of the American Continent held in Punta del Este, Uruguay, on November 3–7, 1975.
The assumption implies that, owing to either domestic or external rationing of foreign funds, the domestic interest rate can diverge from the world interest rate by more than the risk premium that would equalize the rate of return in the borrowing country and the rate of return abroad.
The net capital inflow is defined as disbursements minus amortization payments.
The analysis applies whenever a proportion of the foreign resources is used to finance local costs, such as general government consumption. It applies also when a public investment project would have been undertaken even without foreign financing, insofar as domestic financial resources released from the project are diverted to government consumption expenditure.
If recourse is made to foreign borrowing to neutralize a disequilibrium situation—that is, one caused by exchange rate or aggregate demand mismanagement—then the same analysis would apply. The only difference is that new borrowing would avoid losses in reserves or adjustments in the exchange rate and the level of expenditure.
The increases in output probably will be lagged in time in relation to the increment in investment; the lag will depend upon the maturity of the various projects being undertaken.
Net resource transfer is defined as disbursement minus debt service (amortization payments and interest).
The costs will depend upon the possible future adjustments required in the exchange rate, as these will affect the cost of payments in terms of domestic resources. For extensive treatments of this aspect, see Organization of American States (1973) and Fontaine and Selowsky (1973). In addition to cost-benefit analyses of debt in relation to the exchange rate, these studies include the effect of rising interest costs on additional loans.
The constraint imposed by lenders on the availability of foreign financing to a particular country may be determined by institutional or portfolio considerations. These constraints may originate in the lender’s perception of the risk of delays or default involved in holding a certain proportion of its loans outstanding to a particular country, and are closely linked to the performance of the debtor country. The limitation suggests the existence of market imperfections that prevent the interest rate from fully reflecting the risk involved in lending to various borrowers under different circumstances.
A small increase in the annual rate of growth from the historical 5 per cent to 5.1 per cent is achieved after period 1 as a result of positive net resource transfer from abroad.
A more specific approach within the described context is that of optimization of flows over time. As in the general case explained above, it requires the identification of the supply constraints on foreign funds. In addition, it requires the definition of optimality criteria with respect to the allocation of funds over time. Rather than allowing the targets of growth to be exogenously determined, an optimum pattern of growth could be established that, for example, maximizes the level of GDP over time in the presence of constraints on the supply of foreign funds. The pattern of growth would be the result of a defined pattern of use of foreign funds. In any case, the link between growth and foreign resources is not affected by the pursuance of “optimizing” policies. Such policies simply define the “best” use of foreign resources for any given pattern of growth.
Whenever the available foreign financing is in the form of project loans, rather than general balance of payments support loans, their sustainability will depend on the existence of eligible projects over the medium term. The absence of projects that fulfill the conditions for access to that type of financing will reduce the supply of foreign loans and, therefore, will be reflected in a more restrictive supply constraint.
There appears to be considerable interest in obtaining indicators that would automatically provide an answer to the problem of limitations on indebtedness. Although indicators (e.g., debt service ratio, ratio of debt service to disbursements, ratio of imports to disbursements) will provide insights into past developments, they cannot, by themselves, provide any meaningful debt management guidelines.
The pattern of net resource transfers will basically depend upon the mechanics of debt accumulation and, in particular, on the pattern of disbursements over time. In general, for the net resource transfer to be positive, the rate of growth of debt must be larger than the average interest rate on that debt. If disbursements grow at a constant rate (for constant terms of indebtedness), the net resource transfer will decline up to the moment of the final maturity of the first loan. Thereafter, the net resource transfer will increase (in absolute terms) at the same rate as the disbursements. It will be negative if interest rates are higher than the rate of growth of disbursements, positive in the reverse case. See Dhonte (1975) for a description of the mathematical formulation.
A current account deficit, for a given exchange rate, is, by definition, equivalent to the excess of expenditure over income. This will represent an equilibrium situation (with no change in prices) only at a lower interest rate, at which there will be increased investment and decreased savings, accompanied by additional net capital inflows. Otherwise, the economy will adjust through changes in the relative prices of traded and nontraded goods that will reduce the current account deficit to the original amount.
The impact on the current account may be basically the same as that of exchange rate policies, insofar as taxes or subsidies on traded commodities have effects equivalent to those of exchange rate changes.
The possible decline in government expenditure without a concurrent decline in domestic credit will result in a decline in interest rates that will reflect the reduced financing needs of the public sector. This decline in the rates will offset the improvement in the current account caused by a curtailment of expenditure. The current account will only improve, for a given level of income, if the increase in expenditure in traded goods resulting from the interest rate effect is smaller than the direct impact on the current account arising from the cut in government expenditure.
See Guitian (1973).
In addition to the coordination of exchange rate and credit policies, equilibrium in the domestic economy will also require that interest rates be allowed to adjust upward. This increase will provide for a reduction in expenditure on traded and nontraded goods. The decline in expenditure will offset the excess demand for nontraded goods that was generated by the decline in their relative price resulting from exchange rate depreciation, and will provide for equilibrium in that market. The current account will, therefore, improve as a result of the movement in relative prices and the increased interest rate.
If taxes (t) are a function of income, the left-hand side of the expression becomes (dy/y – ẏ) [1 - (t/y/)·Nty] [y/e - Ney]; this implies that G is government expenditure rather than government deficit.
The autonomous change in the current account reflects the autonomous effect of economic growth on the traded goods sector—that is, the increase in the supply of exports and import substitutes resulting from the allocation of additional resources to those sectors. Changes induced by changes in the exchange rate are dealt with explicitly.
For any dependent variable, the denominator of the equation is Δ = - Ner [(1 - b)X′(EXT - NmT) + a1 - [NeT + NXT X/e] NMr > 0
The domestic interest rate may differ from the rate prevailing internationally as a result of a risk premium. In general, the foreign supply of capital can be thought to be interest elastic—that is, F = F(r); this can be readily introduced into the model.
Although the model assumes an instantaneous maturity of investment, the presence of lags in the initiation of the operation of new investments can be introduced.
The marginal savings rate is most likely variable. It is possible to think of s′ = s (y, r), where ds′/dy > 0 and ds′/dr < 0.
The autonomous investment can be viewed as negative, reflecting the investment required to offset depreciation on the existing capital stock.
It is assumed here that the marginal savings rate relevant for disbursements is the same as that for debt service. A discrepancy between the two could be incorporated into the model.
The inverse of IKOR (incremental capital/output ratio) can be substituted for the yield of additional investment, although this would imply that all the growth in output is attributable to growth in the capital stock.
See Dhonte (1975), pp. 183–84.
A target on increases in reserves can be easily introduced, resulting in a greater required devaluation and a smaller increase in domestic credit.
In the presence of unlimited access to foreign capital, the exchange rate will remain unchanged while capital flows will accommodate the wider current account deficit. Simultaneously, a lower interest rate will allow for increased investment and a lower savings ratio that will be consistent with the current account outcome.
Although the coefficients are more complicated in the general case, the direction of the change will be the same except for changes in domestic prices in response to changes in the exchange rates, which may be negative owing to the effect on real cash balances.
The distribution between the two will depend upon the openness of the economy to external transactions.
For a given increase in income, and decrease in reserves, a given credit expansion will result in smaller rates of increase in domestic prices (P), when it is accompanied by a higher rate of devaluation (T); however, the overall price level (p*) may increase at the same rate in any case.
Whenever the demand for money and traded goods is interest rate elastic, the required direction of change in government expenditure will depend upon the impact of the interest rate. A decline in government expenditure will lead to a smaller budget deficit and, hence, will result in a fall in interest rates. Therefore, when the interest rate elasticity of demand for traded goods is high, an increase in government spending may be required to improve the current account by means of an increase in the interest rate.