Chapter

Chapter III Medium-Term Prospects and Policy Issues in the Developing Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1991
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Introduction

The developing countries, and in particular those with debt-servicing difficulties, face a number of challenges over the medium term. First, there is concern about the implications of the potential demands on global saving by Eastern Europe, the U.S.S.R., the Middle East, and a few other developing countries. Second, although debt-export ratios generally have fallen and there has been some progress in addressing debt-servicing problems, a number of debtor countries continue to face uncertain prospects for normalizing financial relations with their creditors, and the situation in many low-income countries remains a cause for concern. Third, while some countries have successfully tackled macroeconomic and structural problems, in many others progress has been slow or negligible, and in a few cases new imbalances appear to be emerging.

Another area of concern is external trade. More and more developing countries have recognized the benefits of an outward-oriented trade system, and 45 developing countries have launched unilateral trade reform efforts since the start of the Uruguay Round.38 The outcome of the multilateral trade negotiations remains of crucial importance for the developing countries. But the delays in concluding the Round have dimmed the hopes of those who advocate free and multilateral trade as a fundamental ingredient of a growth-oriented strategy.

This chapter presents the staff’s medium-term projections for the developing countries, starting with the baseline scenario and exploring the implications of alternative assumptions about domestic policies and the external environment. In view of the particular uncertainties affecting prospects for Eastern Europe—concerning both domestic policies and the external environment—the key policy issues for countries in that region are reviewed in some detail. The chapter then examines the evolving pattern of international saving flows and evaluates concerns about the potential increase in the demand for external saving stemming from Eastern Europe and the Middle East. The conclusion is that the direct impact of the new demands for saving on the other net debtor developing countries is unlikely to be very large and that the situation should be manageable provided appropriate measures are taken in the industrial countries.

The chapter also provides an assessment of some of the factors influencing the international allocation of saving and considers ways to enhance the economic prospects of indebted developing countries and to increase their ability to attract foreign capital flows. The policy measures required vary from country to country but will generally include a combination of domestic policy reforms, debt restructuring, and, where appropriate, official lending in the form of finance for the development of infrastructure and human capital and support for strong adjustment programs. The chapter concludes with a review of recent developments in the debt strategy and of the contribution that the strategy has made to policy improvements in developing countries and to the restoration of external viability.

Medium-Term Baseline Projections

The medium-term baseline projections for developing countries are presented in Tables A5153 of the Statistical Appendix and summarized in Table 11. The projections for the industrial countries suggest some improvement in the external economic environment for the developing countries over the medium term (Statistical Appendix Table A51). Growth in the industrial countries is projected to recover to an average annual rate of just over 3 percent, while inflation would remain relatively low. Real interest rates would increase a little from current levels but would remain significantly below the levels prevailing through much of the 1980s. Commodity price movements are projected to be slightly more favorable to exporters of primary products than in recent years, although the projected terms-of-trade gains for developing countries as a group would be relatively small.

Table 11.Developing Countries: Indicators of Economic Performance
1983–901991–9211993–961
All developing countries
(Annual changes in percent, or percent of GDP)
Real GDP3.21.14.1
Investment ratio25.224.725.2
Export volume5.20.87.2
Import volume2.92.06.6
Terms of trade-2.2-0.80.3
Consumer prices44.039.622.7
(Annual averages, in billions of U.S dollars)
Trade balance44.9-1.330.2
Current account balance-18.684.0-42.0
Total net external credit244.182.870.5
Memorandum: Net official credit334.535.430.7
Net bank credit49.834.128.5
(As percent of exports of goods and services, period averages)
Total external debt5121.3121.497.7
Debt-service payments17.415.613.4
Of which: interest payments8.88.06.6
1983–901991–9211993–961
Net debtor countries with recent debt-servicing difficulties
(Annual changes in percent, or percent of GDP)
Real GDP1.50.84.2
Investment ratio19.520.222.3
Export volume3.71.15.9
Import volume-2.24.35.0
Terms of trade-2.7-1.70.2
Consumer prices133.471.853.2
(Annual averages, in billions of U.S. dollars)
Trade balance22.64.918.6
Current account balance-19.9-34.4-23.9
Total net external credit225.727.120.0
Memorandum: Net official credit325.717.212.2
Net bank credit43.24.03.4
(As percent of exports of goods and services, period averages)
Total external debt5267.4252.3196.3
Debt-service payments30.928.922.0
Of which: interest payments18.016.812.1
1983–901991–9211993–961
Net debtor countries without debt-servicing difficulties
(Annual changes in percent, or percent of GDP)
Real GDP4.90.53.8
Investment ratio29.727.427.2
Export volume7.00.48.5
Import volume6.4-0.88.2
Terms of trade-0.820.10.3
Consumer prices7.027.48.7
(Annual averages, in billions of U.S. dollars)
Trade balance-17.0-39.3-35.2
Current account balance-8.0-29.3-23.4
Total net external credit218.936.545.0
Memorandum: Net official credit39.215.415.0
Net bank credit46.914.021.8
(As percent of exports of goods and services, period averages)
Total external debt583.885.371.5
Debt-service payments14.413.212.2
Of which: interest payments5.95.65.1

As regards domestic policy assumptions, financial and structural policies in developing countries are assumed to follow program objectives in those countries that are implementing Fund- or World Bank-supported adjustment programs during the projection period. In other cases, projections are generally based on the assumption of unchanged policies. As a result of these policy assumptions, the rate of expansion of broad money is projected to fall from 46 percent in 1991 to an average of 30 percent in 1993–96. Fiscal deficits are generally expected to decline relative to GDP, but large differences among countries are likely to continue, with such countries as Chile, Nigeria, and Thailand projected to show a surplus in the central government accounts, while countries such as Egypt, Sudan, and the U.S.S.R. would continue to run large deficits.

The combination of a broadly favorable external economic environment and the assumed implementation of sound economic policies is projected to result in a significant improvement in economic performance over the medium term. Inflation in the developing countries as a group would decline from 40 percent in 1991–92 to 23 percent in 1993–96, with the steepest decline occurring in countries with adjustment programs. The decline in inflation and other policy improvements are expected to contribute to a strong recovery of domestic saving and investment, particularly in countries with recent debt-servicing difficulties where the investment-output ratio is projected to rise by over 2 percentage points. Total factor productivity is also expected to respond to improved policies; its contribution to the growth of potential output in the net debtor countries is projected to rise from an average of about ½ of 1 percentage point in 1983–90 to 1¾ percentage points in 1993–96.

On the assumption that policy improvements would boost investment and productivity, output growth in the developing world is projected to reach an annual average of about 4 percent during 1993–96. In part, this recovery would reflect the high rates of growth projected for countries in the Middle East, mainly as a result of the assumptions made about postwar reconstruction in Iraq and Kuwait; Israel also would experience rapid growth, owing to recent and prospective immigration. In contrast, the medium-term outlook for the Eastern European countries and the U.S.S.R. remains highly uncertain, with growth averaging only about 1 percent a year projected for this region in 1993–96—considerably less than would be required to reverse the output losses suffered in 1990–92.39 In Africa and the Western Hemisphere, the more favorable external environment and the assumed success of adjustment programs are expected to contribute to stronger growth over the medium term, although the projections for these regions are subject to large downside risks. Asia’s relatively strong economic performance is expected to continue, with growth averaging 5¼ percent in the period 1993–96.

The medium-term balance of payments projections for the developing countries show a current account deficit averaging $42 billion a year during 1993–96. This would be well below the levels projected for 1991–92—which reflect developments in the Middle East—but significantly above the average external deficit for developing countries in the 1980s. Official creditors and commercial banks are projected to make roughly equal contributions to financing the aggregate current account deficit of the developing countries. But for countries with debt-servicing difficulties, net flows of external finance from commercial banks (including, in some cases, further arrears) are projected to remain limited. In contrast, increased financing requirements in countries without recent debt-servicing problems—such as Israel, Korea, Thailand, and Turkey—are projected to be met at least in part by new borrowing from commercial banks. In spite of persistent current account deficits and continued reliance on external financing, debt-export ratios and debt-service ratios in all developing country regions except Europe are projected to decline significantly throughout the medium term, reflecting relatively rapid export growth and the impact of debt-reduction operations.40

Alternative Scenarios

The medium-term baseline projections for developing countries depend heavily on the assumptions about the progress of domestic policy reforms. Although many countries have embarked on adjustment programs, there is uncertainty about the evolution of the political frame work in which these programs will be implemented and about their chances of success. There are also uncertainties in the external environment, including concerns about the strength of the recovery in industrial countries, the outcome of the Uruguay Round of trade negotiations, and the impact of changes in Europe and the Middle East on the availability and cost of external finance to other developing countries.

By convention, the staff’s medium-term projections for the developing countries are based on the assumption that Fund- or World Bank-supported adjustment programs will be successfully implemented; and projections of inflation, growth, and other variables for countries with programs are consistent with the program targets agreed with the authorities. At the end of June 1991, 44 countries were implementing adjustment programs supported by Fund resources and another dozen or so were either close to agreement or projected to implement programs before the end of 1991. Adjustment programs typically include macroeconomic measures designed to cut budget deficits and limit the expansion of domestic credit in order to reduce inflation and payments imbalances and create the necessary conditions for sustainable growth and external viability; in general, they also involve structural measures—such as trade liberalization or public enterprise reform—intended to improve productivity. In the past, however, some programs have been abandoned and others have not achieved their targets. If programs are not implemented in full, inflation is likely to be higher, and growth lower, than projected in the medium-term baseline.41

For purposes of illustration, an alternative scenario has been constructed on the assumption that a failure to implement adjustment programs in full would result in inflation falling more slowly than in the baseline, with detrimental effects on investment and growth. Specifically, it is assumed that, in program countries with very high inflation during 1989–91. the rate of increase in prices would fall only to levels recorded in 1983–88, rather than to the much lower levels projected in the baseline. For program countries that have already made some progress in reducing or containing inflation, it is assumed that only half of any further gains projected between 1989–91 and 1993–96 would be achieved. For countries with programs, the alternative scenario also assumes that—mainly because of higher inflation but also because of slippages in other aspects of the adjustment program—the rise in investment ratios and total factor productivity between 1983–90 and 1993–96 would be only half as large as projected in the baseline. Achievement of even these more modest improvements in performance would still require considerable progress in the implementation of planned reforms. The alternative scenario should therefore not be interpreted as a “worst-case” outcome.

The consequences of policy slippages for the medium-term economic performance of the main groups of developing countries are illustrated in Table 12 using a simple growth-accounting framework.42 For the net debtor countries as a group, average inflation in the alternative scenario would be about 10 percentage points higher than in the baseline, with particularly sharp rises in the Western Hemisphere and among the major heavily indebted countries. Investment ratios would be about ¾ of 1 percentage point lower than in the baseline, with particularly large reductions for countries with debt-servicing difficulties. Of much greater significance, however, are the changes to the projections for total factor productivity growth, which would fall from l¾ percent to 1 percent for all net debtor countries and from 2½ to ¾ of 1 percent for the 15 heavily indebted countries. The growth of potential output would fall from 4½ percent to 3½ percent for net debtor countries as a group; the deterioration in economic prospects would be even more pronounced for the developing countries of Europe and the Western Hemisphere. Moreover, the results presented in Table 12 probably understate the effect of the assumed policy slippages on medium-term growth rates, as the growth-accounting framework used to construct the alternative scenario takes no account of the adverse effects on aggregate demand of lower investment and reduced consumer confidence.

Table 12.Alternative Projections for Inflation and Growth in the Medium Term, 1993–96(Annual averages, in percent or percent of GDP)
InflationInvestment RatioGrowth of Total

Factor Productivity1
Growth of

Potential Output1
BaselineAlternative

scenario
BaselineAlternative

scenario
BaselineAlternative

scenario
BaselineAlternative

scenario
Net debtor countries24.835.525.324.61.81.14.43.6
By region
Africa9.612.921.320.11.00.63.83.2
Asia6.66.829.729.61.61.55.35.2
Europe33.517.623.723.12.61.13.41.9
Middle East12.814.121.321.30.20.24.54.5
Western Hemisphere77.7129.222.420.72.30.73.61.8
By analytical criteria
Countries with recent debt-servicing difficulties53.287.222.320.62.00.63.62.0
Countries without debt-servicing difficulties8.78.827.227.11.71.55.14.9
Fifteen heavily indebted countries68.1116.322.020.22.40.73.71.9
Least developed countries23.824.716.916.01.41.34.34.0
Countries with adjustment programs51.285.823.521.62.20.63.72.0

Uncertainties about the external economic environment also affect the outlook for the developing countries. As indicated in Chapter II, the prospects for sustained growth in the industrial countries are favorable, but the precise timing and magnitude of the recovery from the slowdown in 1990–91 are uncertain. Table 13 illustrates how the outlook for developing countries would change if the annual rate of growth of output in the industrial countries over the period 1991–96 proved to be 1 percentage point lower than envisaged in the baseline. Growth in the net debtor developing countries would be ¼ of 1 percentage point lower in 1991–92 and of 1 percentage point lower over the medium term; as a result, output levels in 1993–96 would on average be about 1 ¼ percent lower than in the medium-term baseline. The developing countries most seriously affected by slower growth in the industrial countries would be the exporters of manufactures, notably those of East Asia—reflecting their openness to trade, and the relatively high income-elasticities of external demand for their products. In contrast, the impact on the poorest, least developed countries would be relatively small, owing partly to the product mix and geographic composition of their exports.

Table 13.Medium-Term Implications for Net Debtor Developing Countries of Slower Growth and Trade Liberalization in Industrial Countries(Differences from baseline, in percent)
Effects on the Average Level of GDP. 1993–96
Effect of 1 percent

slower growth in the

industrial countries
Effect of a 5 percent cut

in manufacturing tariffs

in the industrial countries
Net debtor countries-1.21.4
By region
Africa-0.40.8
Asia-1.72.1
Europe-1.21.2
Middle East-1.82.4
Western Hemisphere-0.80.9
By analytical criteria
Countries with recent debt-servicing difficulties-0.60.9
Countries without debt-servicing difficulties-1.82.0
Fifteen heavily indebted countries-0.70.9
Least developed countries-0.50.9
Countries with adjustment programs-0.60.8
Source: IMF staff estimates based on model simulations

Trade is an important link between the industrial countries and the developing world and the main channel through which growth in industrial countries is transmitted to the developing nations. The outcome of the Uruguay Round of trade negotiations is of vital importance in maintaining and extending these trading links. As Table 13 shows, a liberalization of trade equivalent to a 5 percentage point reduction in tariffs on manufacturing imports by the industrial countries (which would bring tariffs close to zero) is estimated to increase the average level of GDP in the developing countries during 1993–96 by about 1½ percent—about as large as the effect of a 1 percentage point increase in GDP growth in the industrial countries.43 In addition, exporters of agricultural products and textiles among the developing countries stand to benefit further from a reform of trading relations in these two sectors.

Key Policy Issues in Eastern Europe and the U.S.S.R.

The pace of change in the last few years in Eastern Europe and the Soviet Union has been unprecedented: far-reaching programs of reform and stabilization have been adopted in Bulgaria, Czechoslovakia, and Romania; Hungary and Poland, which had already embarked on the systemic transformation from centrally planned to market-based economies, broadened their reform efforts; and Albania began the process of integration into the world economy in 1991. In the U.S.S.R, recent events have increased the probability that substantial economic reforms will be undertaken.

The international community has welcomed these dramatic changes and, by and large, has moved swiftly to support them. The Fund itself has deepened its involvement in the region considerably. Fund arrangements are in place in Bulgaria, Czechoslovakia, Hungary, Poland, and Romania; disbursements to these countries are expected to amount to some $4 billion in 1991. The Group of 24 countries (G-24) established under the coordination of the European Commission44 has succeeded in raising exceptional balance of payments assistance for a number of Eastern European countries implementing reform and stabilization programs. Other international organizations, including the World Bank, have also provided financial support or technical assistance, and substantial additional official financing has been provided under the aegis of the Paris Club.

Much remains to be done, however, both by the countries themselves and by the international community. Recent events demonstrate that, far from slowing down, the transformation in the political and economic character of the region is gathering speed. The U.S.S.R. has indicated its intention to accelerate economic reform and integration with the world trade and payments system. Estonia, Latvia, and Lithuania have declared their commitment to a restructuring of their economic and financial systems and have applied for Fund membership. The challenges for the rest of the world in fostering these momentous changes will be undiminished in the period ahead. Indeed, they are likely to increase, with even greater support from the international community required to ensure a successful transformation, not only in those countries that began the process a year or two ago but also in those that are just setting out.

A number of lessons may be drawn from the experience so far—limited though it is—on the key issues facing the region. It is clear that the process of creating new, market-oriented economies with a predominant role for private enterprise is lengthy and, in many ways, difficult. Governments among the former Eastern European members of the CMEA have moved swiftly to dismantle the controls on prices, trade, and production that seriously distorted resource allocation under central planning. But in order to satisfy the aspirations for higher living standards that have been the driving force behind reform, they must now tackle the much harder task of rebuilding the productive base of their economies in line with appropriate new incentives and world market prices, and on the basis of private enterprise.

Experience in 1991 has been mixed. Governments have moved to 1 iberalize and open their economies with remarkable speed, and the impact of the liberalization on the external sector is being contained. Financial developments have been favorable, and price performance, after an initial deterioration associated with price liberalization, has been broadly satisfactory. There are also clear indications of a quick response from the small-scale, informal private sector. At the same time, it is clear that the adjustment costs associated with economic transformation may be considerably larger—and sustained for longer—than first expected. Economic activity has fallen sharply across the region this year, following widespread declines in 1990. The cumulative drop in output from 1989 to 1991 is tentatively estimated to range from about 10 percent in Czechoslovakia and Hungary, and some 20 percent in Poland and Romania, to as much as 35 percent in Bulgaria. The recent weakness in output reflects to a significant extent the precipitous decline in trade between Eastern Europe and the Soviet Union, as a breakdown of administrative arrangements and a shortage of foreign exchange sharply curtailed imports into the U.S.S.R., as discussed in the Appendix to Chapter I. But the fall in economic activity also reflects the inefficiency of the Eastern European economies and the inevitable lags between policy changes and their effects.

The primary responsibility for carrying through the enormous task of transforming these economies rests at home. Governments must now sustain their commitment to stabilization and structural change to elicit the supply response on which improved living standards depend, including the required financing from the private sector. Rapid progress in building a new institutional framework—and in particular resolving uncertainties about ownership that may deter private investors—will be critical in limiting the fall in output. The strong actions on economic reforms already taken by a number of governments, and endorsed by others just beginning the process, are very encouraging. But even in the countries that embarked earlier on reform, much remains to be done to reduce the role of the state in productive activities and to move to a market economy where the private sector is pre-eminent.

Governments are only just beginning to take essential steps in a number of key areas: the reform and privatization of public enterprises; the implementation of hard budget constraints in the remaining state sector; and the adoption of measures to put the banking and financial systems on a sound footing. At the same time, pressures to relax the stabilization effort, and in particular to ease the fiscal stance, must be resisted if inflation is to be kept under control and external confidence maintained. Slippage in this area will postpone creation of the conditions for sustained economic growth and make the transition to a market economy even more costly.

While it is gratifying that governments have so far reaffirmed their commitment to reform, it is also crucial that early external assistance be provided to alleviate the adjustment burden. Otherwise, the popular support needed to push ahead with reform is likely to wither, especially given already large declines in real wages and rapidly growing unemployment. The two key elements of this external assistance—improved access to industrial country markets and financial support—must complement each other. Expanding external markets are needed to allow these countries to pay for part of the reconstruction costs through their own exports. Financial assistance is needed to cover remaining trade deficits associated with increased investment requirements.

Increased access to export markets is an essential condition for the successful transformation of the economies of Eastern Europe. Major steps have already been taken in many of these countries to liberalize trade and payment systems. The effective dissolution of the trading arrangements of the CMEA earlier this year hastened the process of reorientation. But most of the Eastern European countries—except for some where economic transformation is more advanced, notably Hungary—have not yet succeeded in switching exports from the collapsing CMEA bloc to new markets. Much of these countries’ old export base, dependent on production of manufactured goods intended for the Soviet market and planned on the basis of distorted relative prices, is no longer economically viable. Moreover, in some cases the rapid opening up to external market forces has led to substantial import penetration. These difficulties underline the importance of ensuring access for these countries to markets in which they can compete.

While certain barriers to exports of manufactures have been lowered in industrial countries, major impediments remain in a number of areas in which the countries of Eastern Europe may have a comparative advantage. Against this background, the heads of state or government participating in the London economic summit in July 1991 undertook “to improve further their access to our markets for their products and services, including in areas such as steel, textiles, and agricultural produce.”

The exigencies of the situation add urgency to this important declaration, but recent developments have not been encouraging. It is of the utmost importance that the wish of these countries to integrate their economies with the rest of the world be accommodated as quickly as possible. In this connection, the European Commission, stressing the importance for all of the reforming economies of improved access to the EC market, has proposed that Community members grant trade concessions on a number of sensitive products—including textiles, coal, meat, fruit, and vegetables—in order to speed agreement on EC association for Czechoslovakia, Hungary, and Poland. Of course, it is important to ensure that increased access to these countries does not undercut efforts to achieve multilateral trade liberalization under the aegis of the Uruguay Round.

The need for exceptional financial assistance is likely to continue for some time, even if swifter progress is achieved on trade access. Intime, of course, a successful transition should lead to sustainable external positions as these countries’ exports, together with inflows of private capital, would be sufficient to cover their import needs. But estimates suggest that the capital needs required to bring about this transition, and to bring living standards closer to those in neighboring Western European countries, will be very substantial for some time, and no doubt in excess of the saving that can be mobilized domestically. It is difficult to project financing requirements beyond the near future. Much will depend on the speed with which efficiency gains—which are potentially very large in all these countries as new investments should incorporate the latest technology—can be realized. Given the magnitude of the uncertainties, however, attracting the private capital flows to finance the necessary investment may be difficult.

In sum, steadfast commitment of each country to strong stabilization policies and structural reform will be the key to success. But the response of the international community to the needs of the newly reforming economies also will be critical. A supportive international environment, involving both improved access to markets and timely financial assistance, is essential to the success of reform efforts. Without this support, adjustment would be more costly, raising the risk of a reversal of external liberalization measures and a resort to disorderly adjustment expedients.

The Pattern of International Saving Flows

The importance of combining sound domestic economic policies and adequate external support—which has been emphasized above for the Eastern European countries—applies equally to all net debtor developing countries. Some developing countries are concerned, however, that developments in Eastern Europe and elsewhere might have adverse implications for the success of their own adjustment programs. An important question in this regard is whether restructuring in the previously centrally planned economies of Eastern Europe, together with the requirements for postwar reconstruction in the Middle Fast, will lead to a reallocation of global saving away from the developing countries in Africa, Asia, and the Western Hemisphere and thus hinder their adjustment efforts.

In evaluating this risk, it is useful to examine the magnitude of the flows involved and the importance of external saving as a source of financing for the developing countries. Table 14 shows the medium-term prospects for saving and investment in developing countries in a sources and uses of funds framework. In the developing countries outside the Middle East and Eastern Europe, the contribution of gross external saving to the financing of investment is projected to be substantially lower in the first half of the 1990s than it was in the years prior to the debt crisis. The decline projected between, 1991–92 and 1993–96 would be relatively modest compared with the drop that took place during the 1980s, and the impact on the availability of funds for domestic investment is projected to be offset by a fall in interest payments relative to GDP.

Table 14.Developing Countries: Sources and Uses of Funds in the Medium-Term Baseline1(Annual averages in percent of GDP)
Sources of Funds2Uses of Funds3
Domestic

saving
Gross

external

saving
Transfers

from

abroad
Domestic

investment
Investment

abroad
Net

factor

payments
All developing countries
1975–82426.44.40.826.63.51.5
1983–90525.61.50.625.21.01.5
1991–9224.22.00.324.70.51.3
1993–9625.21.40.525.20.81.1
Eastern Europe and the U.S.S.R.
1975–82
1983–90531.7-0.20.430.50.51.0
1991–9222.91.70.524.2-0.11.0
1993–9623.31.60.624.10.31.0
Middle East6
1975–8237.61.3-0.526.313.2-1.1
1983–9018.61.0-1.122.6-0.6-3.4
1991–9222.44.0-3.725.7-1.2-1.8
1993–9622.21.6-0.223.31.1-0.9
Other countries with debt-servicing difficulties7
1975–8223.05.90.425.11.82.4
1983–9020.42.16.818.41.03.9
1991–9221.01.90.820.10.63.0
1993–9622.81.10.621.90.32.4
Other developing countries
1975–8224.03.41.425.91.71.2
1983–9028.32.21.328.61.91.3
1991–9228.21.80.828.61.30.9
1993–9628.61.50.628.61.40.6

In Eastern Europe and the Middle East, the inflow of gross external saving relative to GDP is projected to be substantially higher than in the 1980s. However, an increase in domestic saving would also play an important role in financing the higher rates of investment projected for 1991–92 in the Middle East, and for 1993–96 in Eastern Europe (excluding the U.S.S.R., where domestic saving and investment are projected to decline). Overall, domestic saving was about six times more important than gross external saving as a source of funds to developing countries even in the years preceding the debt crisis. The projected domestic saving rates for the countries with debt-servicing difficulties would represent a large increase over recent levels, but the evidence from other developing countries and past experience suggest that these rates are attainable, provided there is a stable macroeconomic environment and an increase in government saving.45

Table 15 shows the dollar amounts of past and projected gross and net flows of foreign saving to the developing countries. Clearly, net inflows of foreign saving into the developing countries are considerably smaller than the corresponding gross flows in all periods; this reflects mainly investment abroad by creditor countries and countries with current account surpluses, but also a significant accumulation of foreign assets by several net debtor countries. A rise in both the gross and the net use of external saving is projected for the developing countries of Europe and the Middle East in the 1990s. In the Middle East, increased use of net external saving would be temporary, reflecting in part the projected time profile of reconstruction. In Eastern Europe and the U.S.S.R., the projected net flows amount to about $15 billion a year, although this estimate is subject to a wide margin of uncertainty. Account also needs to be taken of the increased demand for external saving in east Germany. Despite all these additional demands, the projections show slightly higher dollar flows to most other groups of developing countries than in the 1980s.46 In Africa, however, there would be a slight decline in the net use of foreign saving in the 1990s.

Table 15.Use of External Saving by Developing Countries(Annual averages, in billions of U.S. dollars)
1975–821983–901991–9211993–961
Use of gross external saving2
All developing countries79.660.3114.2101.2
Africa12.610.07.26.2
Asia19.424.937.740.3
Europe7.91.816.523.5
Middle East5.16.827.013.3
Western Hemisphere34.616.925.917.8
Net use of external saving3
All developing countries7.018.684.042.4
Africa10.47.37.95.3
Asia8.4-0.811.05.2
Europe3.9-3.017.517.7
Of which: Eastern Europe and the U.S.S.R.1.7-3.915.713.2
Middle East-38.57.430.93.3
Of which: Kuwait and Iraq-9.5-3.319.14.4
Western Hemisphere22.97.716.710.9
Memorandum: Net debtor developing countries49.527.963.747.3

The Effects of Additional Demands on World Saving

The global implications of the additional demands on external saving by Eastern Europe, east Germany, the U.S.S.R., and the Middle East were assessed in Chapter II.47 The effect on the net debtor developing countries (excluding Iraq, Eastern Europe, and the U.S.S.R.) can be examined in more detail with the aid of the developing country models used for forecast adjustment and scenario analysis in the World Economic Outlook exercise. The main effects on the world economy of the additional demands on saving, as described in Chapter II, are higher real interest rates, higher prices for traded goods, and a temporary increase in growth in the industrial countries, followed by slower growth and a lower level of output in the medium term. The effects of these changes on the main groups of net debtor developing countries are presented in Table 16.

Table 16.Simulated Effects on Net Debtor Developing Countries of Projected Additional Demands on World Saving(In percent or percentage points)
19901991Average

1992–96
Net debtor countries
Real GNP0.10.2-0.1
Export volume0.51.00.2
Import volume0.1-0.5
Terms of trade-0.6-0.6-0.5
Current account balance10.20.1
Debt ratio1- 1.8-3.0-1.2
Debt-service ratio1-0.3-0.10.1
By region
Africa
Real GNP0.1-0.2
Export volume0.40.70.1
Import volume0.3-0.8
Terms of trade-0.4-0.3-0.3
Current account balance10.20.1
Debt ratio1-2.0-3.5-2.4
Debt-service ratio1-0.30.1
Asia
Real GNP0.30.40.1
Export volume0.71.20.3
Import volume-0.2-0.4
Terms of trade-0.7-0.8-0.6
Current account balance10.20.1
Debt ratio1-0.7-1.4-0.8
Debt-service ratio1-0.2
Europe (excluding Eastern Europe)
Real GNP0.20.3
Export volume0.40.90.3
Import volume-0.3-0.8
Terms of trade-0.5-0.5-0.4
(Turret account balance1-0.10.30.1
Debt ratio1-1.2-2.9-2.0
Debt-service ratio1-0.2
Middle East (excluding Iraq)
Real GNP0.10.3
Export volume0.30.7
Import volume0.30.70.2
Terms of trade-0.2-0.1
Current account balance1-0.10.2
Debt ratio1-3.7-6.2-2.9
Debt-service ratio1-0.8-0.80.2
Western Hemisphere
Real GNP-0.2
Export volume0.20.5
Import volume0.2-0.8
Terms of trade-0.5-0.4-0.5
Current account balance10.10.1
Debt ratio1-3.9-5.8-1.3
Debt-service ratio1-0.3-0.10.1
By predominant export
Primary products exporters
Real GNP0.10.1-0.1
Export volume0.40.80.2
Import volume0.40.5-0.5
Terms of trade-0.30.1-0.4
Current account balance10.10.6-0.2
Debt ratio1-4.8-8.7-2.5
Debt-service ratio1-0.5-0.40.2
Exporters of manufactures
Real GNP0.10.2
Export volume0.61.10.3
Import volume-0.2-0.1-0,5
Terms of trade-0.5-0.7-0.5
Current account balance10.2
Debt ratio1-1.1-2.0-1.0
Debt-service ratio1-0.1
Fuel exporters
Real GNP-0.2
Export volume0.20.5-0.1
Import volume-0.2-0.4-1.1
Terms of trade-0.6-0.6-0.6
Current account balance10.20.2
Debt ratio1-2.2-9.6-1.5
Debt-service ratio1-0.4-0.10.1
Service and remittance countries
Real GNP0.30.5
Export volume0.61.00.4
Import volume0.51.30.4
Terms of trade-0.5-0.5-0.3
Current account balance10.2-0.50.1
Debt ratio1-3.5-6.1-3.2
Debt-service ratio1-0.8-0.70.3
Diversified exporters
Real GNP0.20.2
Export volume0.71.00.4
Import volume0.30.2-0.5
Terms of trade-1.0-1.0-0.8
Current account balance1-0.3-0.10.2
Debt ratio1-1.0-1.6-0.8
Debt-service ratio1-0.20.10.1
By miscellaneous criteria
Fifteen heavily indebted countries
Real GNP-0.2
Export volume0.20.5
Import volume0.1-0.1-0.8
Terms of trade-0.4-0.3-0.4
Current account balance10.10.2
Debt ratio1-3.4-5.1-1.5
Debt-service ratio1-0.3-0.10.1
By financial criteria
Countries with recent debt servicing difficulties
Real GNP-0.2-0.2
Export volume0.30.60.1
Import volume0.1-0.7
Terms of trade-0.4-0.3-0.3
Current account balance10.10.1
Debt ratio1-3.0-4.7-1.9
Debt-service ratio1-0.3-0.10.1
Countries without debt-servicing difficulties
Real GNP0.20.40.1
Export volume0.61.20.3
Import volume-0.1-0.4
Terms of trade-0.7-0.8-0.6
Current account balance10.2
Debt ratio1-0.9-1.8-0.9
Debt-service ratio1-0.2-0.10.1
By miscellaneous criteria
Least developed countries
Real GNP0.10.1-0.1
Export volume0.40.70.1
Import volume-0.1-0.2-1.0
Terms of trade-0.7-0.4-0.5
Current account balance10.61.20.5
Debt ratio1-4.9-11.1-6.5
Debt-service ratio1-0.30.40.5
Four newly industrializing Asian economics2
Real GNP0.40.80.2
Export volume0.81.60.4
Import volume-0.30.1-0.3
Terms of trade-0.8-1.1-0.7
Current account balance1-0.1
Debt ratio1-0.1-0.3-0.2
Debt-service ratio1-0.1

The estimated net impact on the net debtor developing countries turns out to be small, but not negligible. The higher world interest rates increase debt-service costs, although the effect on debt-service ratios is offset by an increase in the value of exports of goods and services. The stock of external debt remains broadly unchanged, but debt-export ratios fall as a result of higher export values. The level of GDP rises slightly at first, by ¼ of 1 percent in 1991, but by 1996 it would return to its baseline level or fractionally lower, as a result of slower growth in the volume of exports.

Real GNP would decline a little more than GDP over the medium term because of higher interest payments, and real incomes would be further reduced owing to a slight deterioration in the terms of trade. The weakening in the terms of trade would require a reduction in import volumes in countries with limited access to sources of external financing. There is a small improvement in the net debtor countries’ current account balance in 1991 and 1992, reflecting a reduction in their net use of external saving, but little change relative to exports in the medium term. The simulations suggest that the decline in external saving would’be offset in part by a rise in domestic saving in the net debtor countries, but domestic investment would still fall slightly relative to GDP, with the result that potential output would be somewhat lower than in the medium-term baseline.

As indicated in Chapter II, a wide margin of uncertainty is attached to these simulation results and it is possible that in some circumstances, or for certain countries, the adverse effects could be larger than suggested in Table 16. This emphasizes the overriding need for policy measures that will enable the indebted developing countries to increase domestic saving rates and enhance their attractiveness to foreign capital over the medium term.

Factors Limiting Capital Flows to Developing Countries

A number of factors—including political uncertainty, continuing macroeconomic instability, doubts over the course of economic policy, and caution on the part of lenders—continue to limit the flow of capital to the indebted developing countries. Although the return on capital in these capital-scarce countries is potentially relatively high, in practice the flows are expected to be modest (Table 14). The impact of three sets of factors that might limit capital flows to developing countries—domestic policies, externalities in investment, and international credit constraints—is considered below, together with an assessment of the economic policies that would enable the indebted developing countries to increase domestic saving and investment and compete more effectively for global saving in the face of increasing potential demands from Eastern Europe and the Middle East.

Domestic Policies

There is little prospect of an increase in the flow of external saving to developing countries or a rise in domestic saving rates unless there is an improvement in both macroeconomic and structural policies. The uncertainties created by lax monetary and fiscal policies and frequent policy shifts create an environment where investors, both domestic and foreign, are reluctant to commit resources. As a result, external inflows are depressed, capital flight is encouraged, and domestic saving is reduced. In some cases, capital inflows, particularly in the form of direct investment, are also limited by direct controls. The maintenance of an open payments system and adherence to appropriate exchange rate policies are essential to attract inflows of external saving, including the return of flight capital. In other cases, capital flows are inhibited because the inefficiencies arising from structural distortions in the domestic economy—such as price controls, planning requirements, or distortionary taxes—offset the advantages in terms of capital productivity that would otherwise arise from low capital-labor ratios. Policy-related uncertainty and other obstacles to investment introduce a sizable risk premium into lending to many of the developing countries.

Uncertainty is a particularly important element in discouraging domestic and foreign investment, in part because of the irreversible nature of most decisions to invest in plant and equipment.48 In the presence of this asymmetry, even investors who are risk-neutral will prefer to wait for more information on developments that could influence the desirability and timing of the investment. Uncertainty from any source—including variations in the terms of trade, domestic demand, or interest rates—could have this effect, but the impact of uncertainty about policies can be particularly serious. It is therefore essential for governments to win private sector confidence and build up credibility through perseverance in the implementation of policy reforms. This has been recognized in some countries where policy improvements have contributed to a revival of domestic investment. For example, in Chile, domestic private investment recovered strongly during 1984–88, following the years of political crisis and policy uncertainties in the early 1980s.49 More recently in Mexico, the fruits of a sustained adjustment program are now evident in a rising investment rate and Mexico’s return to international capital markets.

The attitude of developing countries toward foreign direct investment is an important determinant of their attractiveness to external capital flows and domestic investment. Several countries, particularly in Southeast Asia, have accorded high priority to attracting foreign investment. But developing countries as a group have not shared fully in the growth of foreign direct investment in the 1980s. A recent study attributes this result to the view prevailing in many developing countries that foreign direct investment is primarily a vehicle for technology transfer, export promotion, or access to foreign exchange, rather than a means for improving resource allocation and reinforcing market mechanisms.50 There is some evidence of a more welcoming attitude toward foreign direct investment in a number of developing countries. For example, India and Bangladesh have recently announced plans to relax industrial controls in order to attract more foreign investment; and Pakistan has streamlined its already relatively liberal foreign direct investment regime. Direct investment is generally being welcomed by countries in Eastern Europe, but it is hampered by uncertainties related to the economic reform process, including the status of property rights.

Externalities in Investment

Private capital flows will not necessarily result in an optimum allocation of resources if there are important externalities in investment. From a social standpoint, private investment in infrastructure and human capital is particularly likely to be sub-optimal because of the externalities associated with investment in these areas. The social returns from such investments are likely to be high in developing countries with limited physical infrastructure and low levels of human capital. Recent research on the determinants of economic growth also emphasizes the external benefits of human capital, which tend to raise the productivity of workers at any given skill level.51 Such arguments underline the importance of project-based international lending from official sources—including the international financial institutions—in the vital areas of infrastructure, education, and health care, particularly in the least developed countries. Further efforts are also required by the developing countries to shift the composition of public spending programs toward investment in physical infrastructure and human capital and away from such less productive uses as subsidies and, in some cases, military spending.

International Credit Constraints and the Debt Burden

The legacy of the debt crisis of the early 1980s continues to exert an important influence on the developing countries’ ability to attract new flows of foreign capital. In some countries, the burden of external debt presents an important obstacle to investment and external financing. Apart from its impact on liquidity, it is now widely recognized that a debt overhang can act as a disincentive to adjustment and capital formation as it creates an expectation that the fruits of adjustment efforts and higher investment eventually may be taxed away in order to service the external debt. There are also efficiency costs associated with a debt overhang: repeated debt reschedulings are costly to negotiate, particularly for small low-income countries with limited administrative resources, and private investment may be diverted from productive uses to activities designed to protect investors’ share of future output 52 Another important aspect of the debt overhang problem is the uncertainty resulting from protracted debt negotiations, which can be highly damaging to investment prospects.

The negative impact of a heavy burden of external debt on domestic investment has been documented in a number of country studies.53 An examination of historical relationships using the World Economic Outlook database also confirms the existence of a negative relationship between debt and investment in a large majority of developing countries.54 The quantitative importance of these relationships should not, however, be overstated. The results presented in Table 17 suggest that a 20 percent reduction in the stock of external debt would increase average investment-output ratios in net debtor countries by less than 1 percentage point. As argued in previous editions of the World Economic Outlook, debt reduction needs to be accompanied by other measures in order to bring about substantial improvements in economic performance.

Table 17.Debt Reduction and Domestic Investment(In percent of GDP)
Estimated Impact of a 20 Percent

Reduction in External Debt on the

Domestic Investment-Output Ratio1
Net debtor countries0.72
By region
Africa1.41
Asia0.24
Europe0.70
Middle East1.93
Western Hemisphere0.73
By analytical criteria
Countries with recent debt-servicing difficulties0.97
Countries without debt-servicing difficulties0.38
Fifteen heavily indebted countries1.00
Least developed countries1.10
Countries with adjustment programs1.01

In addition to its impact on investment, a heavy burden of external debt can also limit external inflows of private capital more directly. Many heavily indebted countries face external credit constraints attributable in part to the high level of their external debt, the risk of default, and the absence of effective mechanisms for enforcing international loan contracts. Capital adequacy requirements and concentration limits, although important for ensuring the health of the international financial system, may also have the effect of constraining private lending to heavily indebted countries. Measures to reduce the burden of debt and other ways of catalyzing private capital flows may therefore be required to increase the attractiveness of the heavily indebted countries to foreign capital.

The combined effect of the factors described above—policy-induced uncertainty, externalities, and a heavy external debt burden—reduces the risk-adjusted, private rate of return below the social rate of return in many developing countries. In these circumstances, some official involvement is needed to enable the indebted developing countries to compete more effectively for foreign capital. In practice, the involvement of official creditors is substantial and takes several forms. Program-based lending is aimed at facilitating the changes in domestic policies required to stabilize the economy and improve the prospects for domestic saving, investment, and private capital flows. Project-based lending—and, in the case of low-income developing countries, overseas development assistance—addresses the need of many developing countries to develop physical infrastructure and human capital, and thus benefit from the external economies associated with these investments. Finally, the current debt strategy (reviewed below) seeks to reduce the obstacles to investment and private capital flows resulting from the debt burden and to create the conditions that would permit heavily indebted countries to regain international creditworthiness and resume sustainable growth.

Review of Recent Developments in the Debt Strategy55

The current debt strategy includes three key elements: the promotion of a favorable external economic environment; measures to restore macroeconomic stability in debtor countries; and the provision of adequate financing, comprehensive debt restructuring, and other measures aimed at restoring external viability. External viability cannot be assessed in terms of a single indicator. In broad terms, however, a country can be viewed as externally viable when actual and contractual debt-service payments have converged, when its debt ratios are manageable, and when private and public sector entities can borrow on a voluntary basis in the domestic and international markets at interest rates that reflect reasonable risk premia. External viability also requires that domestic and external debt can be serviced without threatening a government’s fiscal position or domestic macroeconomic stability. This section reviews recent developments in the debt strategy, including the role of financial assistance provided by external creditors and the impact on debt indicators and external viability. In present circumstances, additional efforts are needed to ensure that all countries adopting the required adjustment measures are not constrained in their development effort by insufficient flows of private capital.

Financing and Debt Reduction Operations

Over the past three years external creditors have strengthened the debt strategy by expanding the number of channels of support for countries with debt-servicing difficulties. These channels now encompass various forms of debt restructuring, including debt and debt-service reduction, the provision of new financing, and in the case of low-income economies, aid on highly concessional terms. Financial support is tailored to individual country circumstances and takes into account the expected flow of external resources, the need for immediate cash flow relief, the country’s ability to implement sound economic programs, and other conditions required to restore external viability.

The provision of net new financing in conjunction with debt reschedulings has remained the largest element of support.56 The total net flow of financing to countries with recent debt-servicing problems continued to increase during 1988–90, but the $82 billion provided over this period reflected almost exclusively net lending from official creditors. Financial assistance from the World Bank and the Fund to indebted developing countries has been a key element of structural adjustment programs. A large part of the financing provided by the World Bank has been directly linked to structural adjustment, while the Fund has provided policy advice and used its revolving financial resources to support policy adjustments and measures aimed at restoring orderly creditor-debtor relations. New financing from commercial banks has remained limited and typically has been linked to debt and debt-service reduction packages or the rescheduling of existing maturities, reflecting the preference of the banks to lower their exposure to developing countries.

Heavily indebted low-income countries also have benefited from special concessional assistance, including coordinated, extraordinary assistance to low-income African countries and new concessional programs from the World Bank and the Fund in support of low-income countries with serious balance of payments difficulties.57 Both institutions have provided low-income countries experiencing debt-servicing difficulties with extensive financial and technical assistance and with funding for debt and debt-service reduction operations. Over the three years 1988–90. $3.4 billion of concessional financing was committed by the Fund to 24 countries under the structural adjustment facility (SAF) and the enhanced structural adjustment facility (ESAF).

Debt and debt-service reduction has become an important element of comprehensive debt-restructuring packages. The reduction in external debt obligations has been achieved through three main channels: official debt forgiveness, including rescheduling through the concessional menu of options provided by the Paris Club; officially supported debt and debt-service reduction agreements with commercial banks; and various market-based debt conversion programs, including debt-equity conversions.

Since 1988, $20 billion of official bilateral debt forgiveness has been granted to 41 countries, although the amount of outright debt stock cancellations has been fairly modest (Table 18). Of the total amount, cancellations of bilateral concessional debt totaled $13 billion.58 To date, 20 countries have concluded restructuring agreements with the Paris Club under the concessional menu of options (Toronto terms), resulting in the consolidation of nearly $6 billion of debt-service payments and debt cancellation of almost $1 billion. The average grant element of Paris Club reschedulings under Toronto terms was about 20 percent, and the reduction in annual interest payments for the countries concerned was about 1½ percent of the amounts consolidated. Concessional terms are offered to countries with low per capita income and chronic balance of payments and debt-servicing problems, provided they have adopted strong adjustment programs. At the July 1991 economic summit in London, the participating countries agreed on the need for additional debt-relief measures for these countries, on a case-by-case basis, going well beyond the relief already granted under Toronto terms; they called on the Paris Club to continue discussions on how these measures could be implemented promptly.

Table 18.Debt Cancellations and Debt Reduction, 1989–90(In billions of dollars, unless otherwise noted)
Debt

Stock

End-1988
Share of

Eligible Debt1

(in percent)
Reduction in

Gross Debt2
Reduction

Relative to

1990 GDP

(in percent)
Change in

Debt Stock

During

1989–90
Debt-GDP

Ratio

End-1990

(in percent)
Countries with debt-servicing difficulties786364336347
Countries that concluded debt-reduction agreements with banks316871237-748
Selected low-income countries receiving debt forgiveness411073631965
Under Toronto terms54571125103
Egypt and Poland684721414-285
Sources: IMF staff estimates: Pans Club Agreed Minutes: and national authorities

In the last two years, six countries have concluded agreements on comprehensive debt reduction packages with commercial banks. The reduction in debt and debt-service payments was achieved through debt buybacks, exchanges of old debt at a discount for new debt, partly collateralized bonds, and exchanges of old debt for new bonds at par value with reduced interest rates. The agreements, which covered approximately 70 percent of the outstanding bank debt of these six countries, provided for $23 billion in debt reduction, including the debt-stock equivalent of debt-service reduction. Of the six countries, Mexico experienced the largest absolute reduction in its external debt while Niger’s commercial bank debt has been completely eliminated.

In addition, several countries, most notably Chile, established debt conversion programs under which their commercial debts could be converted into alternative domestic liabilities through various market-based techniques, including debt-equity swaps. The total amount of debt converted under such schemes during 1984–90 was $66 billion. The face value of debt converted through debt-equity swaps (including large-scale privatization, for example, in Argentina) reached over $10 billion in 1990, and the total cumulative value of swaps since 1984 is estimated at $34 billion. Over the past year, debt conversion activity has increased in several countries that have revived or expanded debt-equity schemes to attract foreign investment in the context of privatization programs.

Debt Relief, Concessionality, and Measures of the Debt Burden

A number of debt and debt-service indicators are commonly used to assess the evolution of a country’s debt burden over time and to serve as a basis for cross-country comparisons of the debt burden. These assessments and comparisons, however, must take into account the fact that many low-income countries have obtained financial assistance on highly concessional terms, and that a number of developing countries have concluded comprehensive debt-restructuring agreements that provide debt relief under a menu of concessional options. This box explains how the concessionality of loans and various forms of debt relief affect the conventional measures of the debt burden.

There are three main forms of concessional debt relief: 1) debt-stock reduction or forgiveness, 2) debt-service reduction, and 3) a lengthening of the repayment period on debt with concessional interest rates. Only the first two options affect conventional measures of the debt burden: debt-stock reduction results directly in a lower debt-GDP ratio, and both debt and debt-service reduction lower the debt-service ratio. In contrast, a lengthening of the repayment period on concessional debt has no effect on either the debt-service ratio or the debt-GDP ratio. However, all three forms of debt relief have an impact on the present value of debt, which provides a more accurate measure of the effective debt burden.1

Chart 24 illustrates three different ways of achieving a reduction in the present value of the debt, assuming that the relevant market interest rate is 9 percent and the debt is payable upon maturity. The two downward sloping lines show the impact on the present value of the debt of reducing the interest rate below the market rate for two different maturities; for example, a 2 percent rate of interest on 10-year debt reduces the present value of the debt to 55 percent of face value. If the debt is contracted at the market interest rate and is repayable in 10 years, debt relief equal to 50 percent of the present value can be achieved by cutting the stock of debt in half (point A in the chart), or by reducing the interest rate to just over I percent (point B). In the case of debt with a concessional interest rate of 2 percent, a 50 percent reduction in the present value of debt can be achieved by extending the term from 10 years (point C) to 30 years (point C). As the interest rate is concessional, the effective debt burden is reduced even though the stock of debt and the amount of annual interest payments remain unchanged. This is because the implicit subsidy (that is, the gap between market and concessional interest rates) accumulates over a longer repayment period. (Of course, a lengthening of the repayment period of debt contracted at the market rate of interest would not reduce its present value.)

Chart 23.Developing Countries: Interest Service and Debt-GDP Ratios1

(In percent)

1 Shaded areas indicate staff projections.

2 Interest due, in percent of exports of goods and services.

Chart 24.Debt Relief, Concessionality, and the Present Value of Debt1

1 These present value calculations use a discount rate of 9 percent and assume that principal is repaid in full at the end of the term. If repayments are made earlier, the degree of concessionality involved in Lower interest rates would be less and therefore the slope of the lines in the diagram would be less steep.

An implication of this analysis is that the higher the degree of concessionality of debt, the lower the effective debt relief provided by a given amount of debt or debt-service reduction. This reflects the fact that the present value of concessional debt is always less than the face value. Therefore, a reduction in the face value will not result in a one-to-one reduction in the present value—that is, in the effective debt burden—but rather in a smaller reduction.

The concessionality of debt also affects the comparability of debt-GDP ratios across countries, even where the debt has never been restructured. Debt-GDP ratios generally have been higher for low-income countries than for other developing countries. For example, in sub-Saharan Africa the average debt-GDP ratio in 1990 was 84 percent, approximately double the ratio of the 15 heavily indebted middle-income countries. However, the debt-GDP ratio overstates the debt burden of sub-Saharan Africa because nearly 40 percent of the region’s debt is at highly concessional interest rates (approximately 2 percent). After adjusting for the degree of concessionality—that is, expressing the debt in present value terms—the debt-GDP ratio in sub-Saharan Africa would decline to 68 percent; it would remain broadly unchanged for middle-income countries, where debt is mainly on commercial terms.

Similarly, the evolution of debt-export and debt-service ratios over time for an individual country (or a group of countries) would accurately indicate the change in the country’s effective debt burden only if there are no major changes in the degree of concessionality over time. For example, if a country refinanced its existing nonconcessional debt with loans on concessional terms, the observed debt-export ratio would not reveal the reduction in the effective debt burden. Alternatively, if a country rescheduled its existing concessional debt with a longer grace or repayment period, the reduction in the present value of debt-service payments would not be reflected in a lower debt-service ratio. Thus, the observed change in conventional debt indicators may not fully reflect the benefits of debt restructuring.

1 Of course, no single measure can capture all aspects of the debt burden. For example, two debts can have the same present value, even though one has a short maturity and the other a long maturity. If it is costly to amortize or roll over loans, then the short-term debt m a y be more burdensome. There may also be cases in which the entire time profile of debt-service payments is relevant, for example, when the aim is to match the debt-service profile to the projected cost and revenue stream of a project. The advantage of the present value measure is that it summarizes complex loan terms in a single number that allows comparison across debts with different term structures, as in the case of market compared to concessional debt. A disadvantage is that present value calculations require more detailed and less readily available data than conventional measures. They also require judgments regarding the appropriate discount rale; for example, it could be argued that the relevant rate for a developing country borrower would be the interest rale on its commercial debt rather than the interest rate prevailing in the lending countries, which would probably be lower.

Impact on Debt Indicators and External Viability

A considerable decline in debt-service and debt-GDP ratios has been the most visible result of the strengthened debt strategy (Chart 23 and box). For the group of net debtor developing countries, the debt-GDP ratio fell by nearly 2 percentage points from its peak in 1986. to 28 percent in 1990.59 Debt-GDP ratios in the group of countries with recent debt-servicing difficulties and the group of 15 heavily indebted middle-income countries declined by 4—6 percentage points. Over the same period the 15 heavily indebted countries also experienced a large decline in the ratio of interest to exports of goods and services. The improvement in the aggregate indicators reflects largely the progress made in the highly indebted middle-income countries with large commercial bank debts. In contrast, the small low-income economies—including those in sub-Saharan Africa—experienced a considerable increase in their debt-GDP ratios over the past five years, while their interest-service ratios have remained broadly unchanged.

Differences in the growth rate of the debt stock are key in explaining the difference in the evolution of debt burden indicators for the small low-income countries and the middle-income highly indebted countries (Table 19). Although both groups of countries have experienced comparable rates of economic growth and similar increases in the volume and value of exports, the debt-export and debt-GDP ratios of the low-income countries have continued to rise while those of middle-income countries have declined. In contrast to the small low-income economies, the highly indebted middle-income countries have experienced relatively little increase in their debt, especially over the past two years, largely because of debt and debt-service reduction and market-based debt conversions. In fact, for the 15 heavily indebted countries, the impact of debt-reduction operations has offset approximately one half the increase in debt attributable to net borrowing (Table 20).

Table 19.Growth of Exports, GDP, and External Debt(Average annual change in percent, unless otherwise noted)
Real

GDP
ExportsChange in

Debt-Export

Ratio
Debt-

Export

Ratio2
Debt-

Service

Ratio2
VolumeValue1Debt
All developing countries
1982–852.91.6-2.58.311.113519.3
1986–903.26.39.26.8-2.212.114.1
Countries with debt-servicing difficulties
1982–851.03.3-2.38.010.525833.1
1986–901.63.05.66.00.426724.6
Fifteen heavily indebted countries
1982–850.63.0-2.46.08.628440.9
1986–901.74.97.44.0-3.224827.9
Small low-income economies
1982–853.00.5-0.411.110.539825.9
1986–903.43.77.710.52.645026.3
Table 20.Decomposition of Changes in Debt Stocks(In billions of U.S. dollars)
Net

Borrowing1
Debt

Reduction2
Other3Total
Countries with debt-servicing difficulties
1982–85126.70.240.3166.8
1986–90133.944.0122.9212.8
Fifteen heavily indebted countries
1982–8570.00.216.786.5
1986–9062.429.756.389.0
Small low-income economies
1982–8527.40.10.427.7
1986–9047.96.414.656.1
Sub-Saharan Africa
1982–8520.50.1-1.119.3
1986–9035.96.435.164.6

In several countries that have concluded debt-restructuring agreements with their external creditors and introduced strong reform programs, the improvement in the various indicators of the overall debt burden has been accompanied by progress toward restoring external viability. Among the low-income countries, the most visible progress has been achieved by countries receiving external assistance in the context of programs linked to SAF and ESAF arrangements. The benefits of domestic policy reforms coupled with adequate external financial support are impressive. During 1988–90, GDP growth in countries in sub-Saharan Africa with SAF and ESAF arrangements averaged 4 percent a year, almost double the growth rate in the region as a whole. While a few countries reduced their need for exceptional financial assistance, in many cases progress has been slower than expected, and the achievements so far could easily be reversed by policy slippages or adverse external developments.

A mixed pattern can also be observed among the middle-income countries. In some countries in this group, progress in restoring external viability and the conditions for sustained economic growth has been limited, even in cases where external financial support has been strong and supplemented by debt and debt-service reduction packages (for example, the Philippines). The number of countries awaiting the completion of negotiations with commercial banks is still large and some of the restructuring packages are likely to pose considerable challenges because of large accumulated arrears, potentially substantial financing requirements, or the expectation of a significant impact on banks’ balance sheets. In such cases, only gradual progress is expected in improving economic performance and restoring confidence in macroeconomic policies; in the near term, a reduction in external liabilities is likely to be achieved mainly through market-based debt conversion schemes and privatization programs.

In contrast, in the two most successful countries (Chile and Mexico), where comprehensive external debtrestructuring packages have been accompanied by strong domestic policies, there has been a substantial decline in domestic interest rates, a considerable repatriation of flight capital, and a gradual resumption of access to international capital markets on a voluntary basis. One of the most important indicators of growing private sector confidence in these two countries’ ability to sustain sound economic policies is the decline in the risk premium on cross-border lending, as evidenced by the increase in the secondary market price for their commercial bank debt (Chart 25). A recovery of confidence and a strong rise in secondary market prices are also evident in Venezuela, despite temporary policy slippages in the first half of 1991. The observed divergence between the levels of risk premia for these three countries and other heavily indebted middle-income countries (including Costa Rica, the Philippines, and Uruguay) that have concluded commercial bank debt-reduction agreements indicates that debt reduction alone cannot restore external viability.

Chart 25.Secondary Market Prices for Developing Country Debt1

(In percent of face value of debt)

Sources: A N Z Bank Report and Salomon Brothers, Inc.

1For Costa Rica, Mexico, and Venezuela, prices are based on stripped yield of par bonds.

There are also other signs that some Latin American countries are on their way to regaining international creditworthiness. During 1989-90, the total amount ofborrowing from international capital markets by Chile, Mexico, and Venezuela reached $15 billion.60 During the first half of 1991, Mexico borrowed $1.7 billion in the international bond markets. Furthermore, a rising proportion of Mexico’s recent new borrowing is not collateralized and the underlying interest rates have fallen to levels reflecting reasonable risk premia. Growing confidence and diminished concerns about the debt overhang have contributed to a large inflow of private capital to Mexico; in 1990 alone, the inflow is estimated at $11.5 billion (including $4.5 billion borrowed by Mexican commercial banks).

Experience to date in implementing the strengtheneddebt strategy confirms that financial support tailored to country circumstances can strengthen prospects for restoring external viability and the conditions for sustained economic growth. In the most difficult cases, the burden of debt may need to be reduced to achieve external viability in the medium term. In the case of many low-income economies, a sustained flow of concessional financing m a y need to be supplemented by greater concessionality in restructuring their bilateral official debt. Finally, the experience of successful countries indicates that the sustained implementation of sound policies is also necessary to restore private sector confidence and thereby encourage investment, capital inflows, and growth.

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