external debt: problems and policies thorvaldur gylfason

External External Debt: Debt: Problems Problems and Policiesand Policies

Thorvaldur Gylfason

It dependsIt dependsIf foreign borrowing is used well,If foreign borrowing is used well,

to finance to finance profitable investmentsprofitable investments, , etc.,etc.,

then borrowing may be a good thingthen borrowing may be a good thing

Many countries have developed with Many countries have developed with the aid of external loansthe aid of external loansThis is how the US built its railways This is how the US built its railways

and how Korea managed to develop and how Korea managed to develop so rapidly from the 1960s onwardsso rapidly from the 1960s onwards

Both countries Both countries paid backpaid back their debts their debts

External debt: External debt: Good or bad?Good or bad?

Many other countries have fared less Many other countries have fared less well with their external debt well with their external debt strategies because ...strategies because ...... they did ... they did notnot use their foreign loans use their foreign loans

wellwell

Too often, countries have borrowed Too often, countries have borrowed abroad to finance consumption, not abroad to finance consumption, not investmentinvestmentConsumption does not increase the Consumption does not increase the

ability of indebted countries to service ability of indebted countries to service their debts, nor does low-quality their debts, nor does low-quality investmentinvestment

But But high-quality investmenthigh-quality investment does does

External debt: External debt: Good or bad?Good or bad?

If the world interest rate is lower If the world interest rate is lower than the domestic interest rate, than the domestic interest rate, the country will be a the country will be a borrowerborrower in in world financial markets world financial markets

Domestic firms will want to borrow Domestic firms will want to borrow at the lower world interest rateat the lower world interest rate

Domestic households will reduce Domestic households will reduce their saving because the domestic their saving because the domestic interest rate moves down to the interest rate moves down to the level of the world interest ratelevel of the world interest rate

Conceptual Conceptual frameworkframework

Real interest rate

0 Saving, investment

Saving

Investment

World interest rate

World equilibrium

Domesticsaving

Domesticinvestment

Domestic equilibrium

Borrowing


0

Saving

World interest rate

Investment

World equilibrium


A

B

C

D

Borrowing


Real interest rate

Saving, investment

0

Saving

Investment

World equilibrium


A

Consumer surplusbefore borrowing

C

B

Producer surplusbefore borrowing

Real interest rate

Saving, investment


0

Saving

World interest rate

Investment

World equilibrium


A

Consumer surplusafter borrowing

B D

CProducer surplusafter borrowing

Borrowing


Real interest rate

Saving, investment

The area D shows the increase in total surplus and represents the gains from borrowing

Before trade After trade Change

Consumer surplusConsumer surplus A A + B + D + (B + D)

Producer surplusProducer surplus B + C C - B

Total surplusTotal surplus A + B + C A + B + C + D + D


Borrowers are better off and Borrowers are better off and savers are worse offsavers are worse off

Borrowing raises the economic Borrowing raises the economic well-being of the nation as a whole well-being of the nation as a whole because the gains of borrowers because the gains of borrowers exceed the losses of saversexceed the losses of savers

If world interest rate is If world interest rate is aboveabove domestic interest rate, savers are domestic interest rate, savers are better off and borrowers are worse better off and borrowers are worse off, and nation as a whole still off, and nation as a whole still gainsgains

Gains from trade: Gains from trade: Three main Three main conclusionsconclusions

Debt stockDebt stockUsually measured in dollars or other Usually measured in dollars or other

international currenciesinternational currenciesbecause because debt needs to be debt needs to be

servicedserviced in foreign currency in foreign currency

Debt ratioDebt ratioRatio of external debt to GDPRatio of external debt to GDPRatio of external debt to exportsRatio of external debt to exports

More useful for some purposes, More useful for some purposes, because because export earnings reflect the export earnings reflect the ability to service the debtability to service the debt

External debt: External debt: Key conceptsKey concepts


Debt burdenDebt burdenAlso called Also called debt service ratiodebt service ratio

Equals the ratio of amortization Equals the ratio of amortization and interest payments to and interest payments to exportsexports

q = debt service ratioA = amortizationr = interest rate DF = foreign debtX = exports

X

rDAq

F

Interest burdenInterest burdenRatio of interest payments to Ratio of interest payments to

exportsexports

X

Aa q = a + bq = a + b

Amortization burdenAmortization burdenAlso called Also called repaymentrepayment burden burden

Ratio of amortization to Ratio of amortization to exportsexports

X

rDb

F


Magnitude of the debtMagnitude of the debtDebt should not become too largeDebt should not become too large

How large is too large?How large is too large?

Measurement of the debtMeasurement of the debtGross or net?Gross or net?

May subtract foreign reserves in excess May subtract foreign reserves in excess of 3 months of imports of 3 months of imports

Composition of the debtComposition of the debtFDI, portfolio equity, long-term loans, FDI, portfolio equity, long-term loans,

short-term loansshort-term loans

External debt: External debt: Magnitude and Magnitude and compositioncomposition

Composition of the debtComposition of the debtForeign direct investmentForeign direct investment

Least likely to flee, most desirableLeast likely to flee, most desirable

Portfolio equityPortfolio equity

Long-term loansLong-term loans

Short-term loansShort-term loansMost volatile, least desirableMost volatile, least desirable

As a rule, outstanding short-term As a rule, outstanding short-term debt should not exceed foreign debt should not exceed foreign reservesreserves

External debt: External debt: Magnitude and Magnitude and compositioncomposition

Indonesia Indonesia

and Korea and Korea

broke this broke this

rule in rule in

19961996

How can we figure out a How can we figure out a country’s debt burden?country’s debt burden?Divide through definition of Divide through definition of qq by by

incomeincomeNow we have expressed Now we have expressed the debt service ratio in the debt service ratio in terms of familiar terms of familiar quantities: the interest quantities: the interest rate rate rr, the debt ratio , the debt ratio DDFF/Y/Y, and the export , and the export ratio ratio X/YX/Y as well as the as well as the repayment ratio repayment ratio A/YA/Y

Y

XY

Dr

Y

A

q

F

External debt: External debt: NumbersNumbers

Suppose that Suppose that r = 0.06r = 0.06

DDFF/Y = 0.50/Y = 0.50

A/Y = 0.05A/Y = 0.05

X/Y = 0.20X/Y = 0.20

4.02.0

08.0

0.2

5.006.005.0q

Here we have a Here we have a country that has to country that has to use use 40% of its export 40% of its export earningsearnings to service to service its external debtits external debt

Heavy burden!Heavy burden!

Y

XY

Dr

Y

A

q

F

Numerical exampleNumerical example

African countries:African countries: External External debtdebt 1999 (% of exports) 1999 (% of exports)

0 200 400 600 800 1000 1200 1400 1600 1800

BotswanaSwazi land

Seychel lesE quator ial Guinea

South Af r icaE r i tr ea

Cape Ver deLesotho

Maur i tiusGambia, T he

BeninGabon

AngolaBur kina Faso

ZimbabweMozambique

SenegalNiger ia

GhanaKenya

Mal iChadT ogo

Cote d'Ivoi r eUgandaMalawi

Congo, Rep.Comor os

Camer oonGuinea

MadagascarNiger

Centr al Af r ican Republ icT anzaniaE thiopia

Maur i taniaZambia

RwandaBur undi

Guinea-BissauSier r a Leone

Sao T ome and P r incipeSudan

Ceiling

0 50 100 150 200 250 300 350 400 450 500

BotswanaSwazi land

E r i tr eaSouth Af r icaBur kina Faso

UgandaMozambique

Seychel lesCape Ver de

RwandaE quator ial Guinea

BeninChad

LesothoKenya

SenegalT anzania

Centr al Af r icanE thiopia

NigerMal i

Maur i tiusGhana

Gambia, T heComor os

GuineaCamer oonZimbabwe

MadagascarT ogo

MalawiNiger iaBur undi

GabonCote d'Ivoir eSier r a Leone

Maur i taniaSudan

ZambiaAngola

Congo, Rep.Guinea-Bissau

Sao T ome and P r incipe

African countries:African countries: External External debtdebt 1999 1999 ((% of GDP% of GDP))

Ceiling

0 10 20 30 40 50

Congo, Rep.E quator ial Guinea

BotswanaE r i tr ea

Swazi landSeychel les

Niger iaSudan

Gambia, T heT ogo

LesothoChad

Maur i tiusBenin

Cape Ver deMalawi

Centr al Af r ican Republ icMal i

South Af r icaBur kina Faso

Comor osGuinea

Guinea-BissauSenegal

T anzaniaE thiopia

MadagascarNigerGabonGhana

MozambiqueAngola

Camer oonUganda

ZimbabweCote d'Ivoir e

KenyaMaur i tania

Sao T ome and P r incipeRwanda

Sier r a LeoneBur undiZambia

African countries: African countries: External External debt servicedebt service 1999 (% of 1999 (% of exportsexports))

Ceiling

African countries:African countries: ExportsExports 1999 (% of 1999 (% of GDPGDP))

0 20 40 60 80 100 120

RwandaBurundiEritrea

Burkina FasoUganda

MozambiqueTanzaniaEthiopia

Sierra LeoneNigerBenin

Central Af ricanChad

GuineaZambia

Cape VerdeCameroon

KenyaMadagascar

MaliSouth Af rica

ComorosGuinea-Bissau

MalawiBotswana

TogoSenegal

GhanaSao Tome and Principe

NigeriaMauritania

Cote d'IvoireGabon

ZimbabweGambia, The

NamibiaMauritius

SeychellesCongo, Rep.

Equatorial GuineaSwaziland

Average

African countries:African countries: Current Current account balanceaccount balance 1999 (% of 1999 (% of GDPGDP))

-60 -40 -20 0 20

Eritrea

Lesotho

Seychelles

Sudan

Burkina Faso

Gambia, The

Cape Verde

Uganda

Ethiopia

Chad

Ghana

Niger

Tanzania

Benin

Senegal

Cameroon

Guinea

Central Af rican Republic

Burundi

Angola

Mauritius

South Af rica

Rwanda

Kenya

Cote d'Ivoire

Nigeria

Swaziland

Namibia

Botswana

Mauritania

Average

African countries:African countries: Gross Gross foreign reservesforeign reserves 1999 (months 1999 (months of imports)of imports)

0 5 10 15 20 25

Camer oonE quator ial Guinea

GabonCongo, Rep.

ZambiaSeychel les

AngolaSudanNiger

Cote d'Ivoir eGhana

NamibiaT ogo

Cape Ver deMadagascar

ZimbabweChad

GuineaSouth Af r ica

KenyaMalawiSenegal

E thiopiaSier r a Leone

Maur i tiusSwazi landT anzania

Gambia, T heMal i

MozambiqueBur kina Faso

Bur undiGuinea-Bissau

UgandaBenin

Maur i taniaCentr al Af r ican Republ ic

Sao T ome and P r incipeLesothoRwanda

Comor osBotswana

Ceiling

African countries:African countries: Short-term Short-term debtdebt 1999 (% of foreign 1999 (% of foreign reserves)reserves)

0 10 20 30 40 50

BotswanaLesothoUganda

MozambiqueSwazi land

Gambia, T heE thiopia

Bur kina FasoMalawiRwanda

ChadBenin

Cape Ver deMal i

Centr al Af r ican Republ icComor os

GuineaSenegal

Maur i taniaT anzania

KenyaMaur itius

Bur undiT ogo

GhanaMadagascar

Seychel lesNiger

Sao T ome and P r incipeZimbabwe

Cote d'Ivoir eSouth Af r ica

Guinea-BissauSier r a Leone

ZambiaAngola

E quator ial GuineaSudan

Congo, Rep.Gabon

Ceiling

Debt accumulation is, by its Debt accumulation is, by its nature, a nature, a dynamicdynamic phenomenon phenomenonA large stock of debt involves high A large stock of debt involves high

interest payments which, in turn, interest payments which, in turn, add to the external deficit, which add to the external deficit, which calls for further borrowing, and so calls for further borrowing, and so on on Debt accumulation can develop into a Debt accumulation can develop into a

vicious circlevicious circle

How do we know whether a given How do we know whether a given debt strategy will spin out of control debt strategy will spin out of control or not?or not?To answer this, we need a little To answer this, we need a little

arithmetic arithmetic

External debt External debt dynamics dynamics

Recall balance of payments Recall balance of payments equation:equation:BOP = X – Z + FBOP = X – Z + F

wherewhere

FF = capital inflow = capital inflow = = DDFF where where

DDFF = foreign debt = foreign debtCapital inflow, F, thus involves an Capital inflow, F, thus involves an

increase in the stock of foreign increase in the stock of foreign debt, Ddebt, DFF, or a decrease in the stock , or a decrease in the stock of foreign claims (assets)of foreign claims (assets)

So, F is a So, F is a flowflow and D and DF F is a is a stockstock

External External debtdebt dynamicsdynamics

Now assumeNow assumeZ = ZZ = ZNN + r + rDDFF

ZZ = total imports= total importsZZNN = non-interest imports = non-interest importsrrDDFF = interest payments = interest payments

Further, assumeFurther, assumeX = ZX = ZNN

BOP = 0BOP = 0 A flexible exchange rate maintains A flexible exchange rate maintains equilibrium in the balance of payments at equilibrium in the balance of payments at

all times all times

Then, it follows thatBOP = X – Z + BOP = X – Z + DDFF = = 00so that

DDFF = = rDrDFF

In other words:

rD

ΔDF

F

External External debtdebt dynamicsdynamics

So, now we have:

rD

ΔDF

F

Now subtract growth rate of output from both sides:

g-rY

ΔY

D

ΔDF

F

Y

Yg

External debtExternal debt dynamicsdynamics

But what is

This is proportional change in debt ratio:

Y

ΔY

D

ΔDF

F

??

Y

D

Y

DΔ

Y

ΔY

D

ΔDF

F

F

F

This is an application of a simple rule of arithmetic:

%%(x/y) = (x/y) = %%x - x - %%yy

External debtExternal debt dynamicsdynamics

z = x/yz = x/y

log(z) = log(x) – log(y)log(z) = log(x) – log(y)

log(z) = log(z) = log(x) - log(x) - log(y)log(y)

But what is But what is log(z) log(z) ??

So, we obtain

z

Δz

z

1

dt

dz

dt

dlog(z)Δlog(z)

y

Δy

x

Δx

z

Δz

Q.E.D.

Proof Proof

We have shown thatWe have shown that

grd

Δd

where

Debt ratio

Time

r r g g

r = gr = g

r r g g

Need economic Need economic

growth to keep growth to keep

the debt ratio the debt ratio

under controlunder control

Y

Dd

F

Debt, interest, and Debt, interest, and growth growth

It is important to keep It is important to keep economic economic growthgrowth at home at home aboveabove – or at least – or at least not far below – the not far below – the world rate of world rate of interestinterest

Otherwise, the debt ratio keeps rising over Otherwise, the debt ratio keeps rising over timetime

External deficits can be OK, even over External deficits can be OK, even over long periods, as long as external long periods, as long as external debt does not increase faster than debt does not increase faster than output and the debt burden is output and the debt burden is manageable to begin with manageable to begin with

A rising debt ratio may also be OK as A rising debt ratio may also be OK as long as the borrowed funds are long as the borrowed funds are used efficientlyused efficiently

Once again, Once again, high-quality investment high-quality investment is keyis key

What can we learn What can we learn from this? from this?

Let us now study the interaction Let us now study the interaction between trade deficits, debt, and between trade deficits, debt, and growthgrowth

Two simplifying assumptions:Two simplifying assumptions:DDtt = aY = aYt t (omit the superscript F, so D = (omit the superscript F, so D =

DDFF))

Trade deficit is constant fraction Trade deficit is constant fraction aa of of outputoutput

YYtt = Y = Y00eegtgt

Output grows at constant rate Output grows at constant rate gg per per yearyear

Y

t

Exponential growth

Debt dynamics: Debt dynamics: Another look Another look

Y

time

Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate

log(Y)

time

1

g

Pictures of growth Pictures of growth

T

0

tT dtΔDD at time T

Debt as the sum of Debt as the sum of past deficits past deficits

dteaYdtΔDDT

0

gt0

T

0

tT

T

0

tT dtΔDD at time T

DebtDebt as the sum of as the sum of past deficits past deficits

dteaYdtΔDDT

0

gt0

T

0

tT

gt0

T

0

gt0

T

0

tT eg

1aYdteaYdtΔDD

Evaluate this Evaluate this integral integral between 0 and between 0 and TT

T

0

tT dtΔDD at time T

DebtDebt as the sum of as the sum of past past deficitsdeficits

dteaYdtΔDDT

0

gt0

T

0

tT

gt0

T

0

gt0

T

0

tT eg

1aYdteaYdtΔDD

Evaluate this integral between 0 and T

1eg

1aYe

g

1aYdteaYdtΔDD gT

0gt

0

T

0

gt0

T

0

tT

T

0

tT dtΔDDSo, as T goes to So, as T goes to infinity, Dinfinity, Dtt becomes becomes infinitely large.infinitely large.But that may be quite But that may be quite OK in a growing OK in a growing economy!economy!

at time T

Debt as the sum Debt as the sum of past deficitsof past deficits

T

0gt

0

T

T

Y

YeY

g

a

Y

D

Debt as the sum Debt as the sum of past deficits of past deficits

T

0gt

0

T

T

Y

YeY

g

a

Y

D

T

0

T

0gt

0

T

T

Y

Y1

g

a

Y

YeY

g

a

Y

D


T

0gt

0

T

T

Y

YeY

g

a

Y

D

T

0

T

0gt

0

T

T

Y

Y1

g

a

Y

YeY

g

a

Y

D

gT

T

0

T

0gt

0

T

T e1g

a

Y

Y1

g

a

Y

YeY

g

a

Y

D


So, as T goes So, as T goes to infinity, to infinity, DDTT/Y/YTT approaches approaches the ratio the ratio a/ga/g

T

0gt

0

T

T

Y

YeY

g

a

Y

D

T

0

T

0gt

0

T

T

Y

Y1

g

a

Y

YeY

g

a

Y

D

gT

T

0

T

0gt

0

T

T e1g

a

Y

Y1

g

a

Y

YeY

g

a

Y

D

g

a

Y

D

T

Tlim T


SupposeSupposeTrade deficit is 6% of GNPTrade deficit is 6% of GNP

a = 0.06a = 0.06

Growth rate is 2% per yearGrowth rate is 2% per yearg = 0.02g = 0.02

Then the debt ratio approachesThen the debt ratio approachesd = a/g = 0.06/0.02 = 3d = a/g = 0.06/0.02 = 3

This point will be reachedThis point will be reached regardless of the initial regardless of the initial position ...position ...... as long as ... as long as aa and and gg remain remain

unchangedunchanged

Debt ratio

Time

3

Numerical Numerical example example

Must adjust policiesMust adjust policies

Must eitherMust eitherReduce trade deficitReduce trade deficit by stimulating by stimulating

exports or by reducing imports, orexports or by reducing imports, or

Increase economic growthIncrease economic growth

Otherwise, the debt ratio will reach Otherwise, the debt ratio will reach unmanageable levels, unmanageable levels, automaticallyautomaticallyNo country can afford an external No country can afford an external

debt equivalent to three times debt equivalent to three times annual outputannual output

What to conclude?What to conclude?

Because the debt burden then Because the debt burden then becomes becomes unbearableunbearableRecall our earlier numerical Recall our earlier numerical

exampleexamplewhere we looked at the relationship where we looked at the relationship

between the between the debt ratiodebt ratio and the and the debt debt burdenburden

Korea is a case in pointKorea is a case in pointIts Its export-oriented growth strategyexport-oriented growth strategy

reduced the numerator and increased reduced the numerator and increased the denominator of the debt ratio, the denominator of the debt ratio, thereby quickly reducing the country’s thereby quickly reducing the country’s debt burden debt burden

An An import-substitution strategyimport-substitution strategy would would reduce both numerator and denominator reduce both numerator and denominator with an ambiguous effect on the debt with an ambiguous effect on the debt burdenburden

And why not?And why not?

Suppose that r = 0.06 (as before)

D/Y = 3D/Y = 3 (our new number)

A/Y = 0.05 (as before)

X/Y = 0.20 (as before)

Here we have Here we have a country a country whose entire whose entire export export earnings do earnings do not suffice to not suffice to service its service its debtsdebtsHeavy Heavy

burden, burden,

indeed!indeed!

15.10.2

30.060.05q

Y

XY

Dr

Y

A

q

F

Numerical Numerical example, againexample, again


D/Y = 2D/Y = 2 (our new number)


X/Y = 0.20 (as before) Heavy Heavy

burden, still!burden, still!

85.00.2

20.060.05q

Y

XY

Dr

Y

A

q

F



D/Y = 1D/Y = 1 (new number)




55.00.2

10.060.05q

Y

XY

Dr

Y

A

q

F



D/Y = 0.4D/Y = 0.4 (new number)




37.00.2

4.00.060.05q

Y

XY

Dr

Y

A

q

F



D/Y = 0.4D/Y = 0.4 (as before)


X/Y = 0.30 (new number)Heavy burden, Heavy burden,

but but

manageable!manageable!

25.00.3

4.00.060.05q

Y

XY

Dr

Y

A

q

F


0 50 100 150 200 250 300 350 400 450 500

BotswanaSwazi land

E r i tr eaSouth Af r icaBur kina Faso

UgandaMozambique

Seychel lesCape Ver de

RwandaE quator ial Guinea

BeninChad

LesothoKenya

SenegalT anzania

Centr al Af r icanE thiopia

NigerMal i

Maur i tiusGhana

Gambia, T heComor os

GuineaCamer oonZimbabwe

MadagascarT ogo

MalawiNiger iaBur undi

GabonCote d'Ivoir eSier r a Leone

Maur i taniaSudan

ZambiaAngola

Congo, Rep.Guinea-Bissau

Sao T ome and P r incipe

African countries:African countries: External External debtdebt 1999 1999 ((% of GDP% of GDP))Recap

Recap

0 10 20 30 40 50

Congo, Rep.E quator ial Guinea

BotswanaE r i tr ea

Swazi landSeychel les

Niger iaSudan

Gambia, T heT ogo

LesothoChad

Maur i tiusBenin

Cape Ver deMalawi

Centr al Af r ican Republ icMal i

South Af r icaBur kina Faso

Comor osGuinea

Guinea-BissauSenegal

T anzaniaE thiopia

MadagascarNigerGabonGhana

MozambiqueAngola

Camer oonUganda

ZimbabweCote d'Ivoir e

KenyaMaur i tania

Sao T ome and P r incipeRwanda

Sier r a LeoneBur undiZambia

African countries: African countries: External External debt servicedebt service 1999 (% of 1999 (% of exportsexports))

RecapRecap

Borrowers often renegotiate the Borrowers often renegotiate the terms of their loans in mid-stream terms of their loans in mid-stream in order toin order to delay repayments, that is, extend the delay repayments, that is, extend the

maturity of the loans, or tomaturity of the loans, or toreduce interest payments by replacing reduce interest payments by replacing

high-interest loans by loans with lower high-interest loans by loans with lower interestinterest

Sometimes, outright Sometimes, outright debt debt forgivenessforgiveness may be called for may be called forBut debt forgiveness is But debt forgiveness is no substitute for no substitute for

sound economic policiessound economic policies Remember: our formula Remember: our formula d = a/gd = a/g holds in holds in

the long run regardless of initial the long run regardless of initial conditions conditions

Debt renegotiations Debt renegotiations and forgiveness and forgiveness

External borrowing is a necessary External borrowing is a necessary and natural part of economic and natural part of economic developmentdevelopmentThis requires countries that borrow to This requires countries that borrow to

invest the funds borrowed in invest the funds borrowed in high-high-quality capitalquality capital

This is necessary to be able to service This is necessary to be able to service the debt the debt

If debt burden becomes too heavy, If debt burden becomes too heavy, must either must either reduce deficitreduce deficit or or spur spur growthgrowthIt is always desirable anyway to do It is always desirable anyway to do

everything possible to encourage everything possible to encourage economic growtheconomic growth

Rapid growth allows more foreign Rapid growth allows more foreign borrowing without making the debt borrowing without making the debt burden unmanageable burden unmanageable

In conclusion

external debt: problems and policies thorvaldur gylfason

Documents

investment slide

rate domestic households

lower world

investment consumption

b d c producer surplus

c b producer surplus

foreign borrowing

highquality investment