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.
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.
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.
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.