Deck 13: Balance of Payments, Debt, Financial Crises, and Stabilization Policies

Question 1

Draw up a balance of payments table similar in format to Table 1, using the most recent data from any developing country (consult the IMF's International Financial Statistics at http://imfstatistics.org/imf, or for broader coverage, see links in http://imf.org/external/data.html for the most recent data). Explain the significance of the various entries in the current and capital accounts. What is the status of the country's international reserves, and how do they compare with those of one year ago?
TABLE 1 A Hypothetical Traditional Balance of Payments Table for a Developing Nation

Answer 1

The following table gives the Balance of payment of India
Current account of balance of payment consists of balance of trade, balance of services, investment income, debt service payments, and net remittances and transfers.
Balance of trade could be either positive or negative. Positive balance signifies that country's export of goods is more than its import of goods whereas negative balance signifies that country's import of goods is more than its export of goods.
Balance of service could also be either positive or negative. Positive balance signifies that country's export of services is more than its import of services whereas negative balance signifies that country's import of services is more than its export of services.
Net investment income signifies whether income in terms of interest and dividends on stocks, bonds, and bank deposits is flowing in or out of the country. Positive balance implies income is flowing into the country which means resident of the country has more investment abroad than foreign nationals have in respective country and vice versa.
Debt service payment implies the payment of interest and principal repayment. Significance of this item is that larger amount in this section indicates that country concerned has heavy accumulated debt and its debt service ratio is high which is a cause of concern.
Capital account of balance of payment consists of value of foreign direct investment, foreign loans by private international banks, and loans and grants from foreign governments and multilateral agencies. It also includes resident capital flows as well.
Significance of foreign direct investment, foreign loans by private international banks, and loans and grants from foreign governments and multilateral agencies is that it indicates especially foreign direct investment that country is attracting enough resources in terms of industrial investment, infrastructure investment, and social sector investment. With limited resources at their disposal, developing countries are very much dependent on these sources to undertake various development projects.
Resident capital flows is important in terms that it indicates the seriousness of the problem of capital flight. India has $319 million as international currency reserve as on January 2013 whereas a year ago that is on January 2012, it has $311 million as international currency reserves. So, India has experienced an increase in its international reserves.

Question 2

Describe the basic-transfer mechanism. Using the list of credits and debits in Table 1, identify which ones would fit into the basic-transfer equation. How does the basic transfer help us analyze developing-world debt problems?
TABLE 1 Credits and Debits in the Balance of Payments Account

Answer 2

Basic - Transfer Mechanism
Basic-Transfer mechanism states the difference between the net capital flowing into the country and interest payment made by the country on the debt already accumulated by the respective country.
Basic transfer mechanism acts as an important concept in the respect that it indicates how much amount of foreign exchange the respective country is gaining or losing each year from international capital flows.
Following equation represents the Basic-Transfer Mechanism Where,
BT = Basic Transfer
d = Percentage rate of increase in total debt
r = Average rate of interest to be paid on accumulated debt
D = Total accumulated foreign debt
As per this equation,
Basic transfer would be positive if d is greater than r. This indicates that country concerned is gaining foreign exchange.
Basic transfer would be negative if d is smaller than r. This indicates that country concerned is losing foreign exchange.
The basic transfer helps us to analyze developing world debt problems in the sense that basic transfer equation points out that respective developing country is gaining the foreign exchange or losing the foreign exchange.
If the country is gaining the foreign exchange as shown by positive basic transfer equation then it indicates that respective country is utilizing the foreign exchange for productive investment and is also having favorable balance of payment position as well. In addition to this it is also servicing its debt satisfactorily. These factor further prompts lending and flow of private foreign capital to the country and help it in accumulating resources required for implementing policies needed for long term development.
On the other hand, if the country is losing the foreign exchange as shown by negative basic transfer equation then this indicates that average rate of interest is exceeding the percentage rate of increase in external debt. This point towards the fact that foreign capital outflow exceeds the foreign capital inflows into the country.
When basic transfer equation becomes highly negative it severely restricts the ability of a country to service external debt and debt crisis in such situation becomes self-reinforcing leading to downward spiral of negative basic transfer, dwindling foreign reserves, and stalled development prospects.

Question 3

Trace the evolution of the developing-country debt problem during the 1970s and 1980s. What were the key ingredients? Explain your answer.

Answer 3

The developing country debt problem during 1970s and 1980s got evolved during the 1974-1979 period. During this period international lending has shown tremendous expansion. This has happened because from period of 1967 to 1973, many developing countries were growing at rate in excess of 6 percent per annum. These countries are also pursuing industrialization strategy as well and therefore are importing capital goods, oil, and food in increased quantities. In pursuance of outward-looking development strategies they are also expanding their exports aggressively as well. However, in face of first oil shock in 1974 and worldwide recession, developing countries increased their borrowings so as to maintain their high growth rates. Most borrowing during this period was non-concessional borrowing and that also from commercial and other private lenders. Even though lending from official sources was available but that was not sufficient for the borrowing countries. Moreover, lending from official sources such as IMF comes with painful policy adjustments which developing countries generally wants to avoid.
Apart from this, after first oil shock, period from 1974-1979 was that of congenial economic atmosphere. This enabled the developing countries to maintain relatively high growth rates and service their debt in easier manner thus prompting them to accumulate more debt.
However, after second oil shock of 1979, economic conditions around the world become worse that is there is 360 degree turn in economic conditions. Developing countries are now facing the increased oil prices which in turn is increasing their oil import bill and affecting the import of capital goods as well.
Situation become more pronounced on account of increase in interest rates as implemented by the developed countries as part of their economic stabilization policies leading to capital flight to these countries and increase in interest rate on money to be borrowed from private sector sources by developing countries.
Secondly, slow growth of developed countries and fall in export prices of primary products also adversely affected the export earnings of developing countries and thus severely restricting their debt servicing ability.
With already huge debt and debt servicing obligations, higher interest rate compounded the problems further and created the debt problem for developing countries.
Key Ingredients are as follows -
1. Most borrowing as done by the developing countries during 1970s and 1980s was done through the private sources such as commercial banks and other private lenders.
2. During this period, most of debt was taken by the developing countries on non-concessional terms. Characterized by shorter maturities and market determined rate of interest.
3. During the entire period of debt accumulation, developing countries has experienced enormous out flow of private capital.
4. Commercial banks as flushed with petro dollars and low demand for capital from industrialized nations are competing aggressively to lend to developing countries on favorable terms.

Question 4

Why was the problem of capital flight so serious in some highly indebted countries? What causes capital flight, and what do you think can be done about it?

Question 5

What is petrodollar recycling, and how did it contribute to the debt crisis of the 1980s? Why were developing countries so eager to borrow money from international banks? Explain your answer.

Question 6

What is the significance of the debt service ratio? Can indebted countries do anything to lower this ratio? Explain your answer.

Question 7

Describe the typical IMF stabilization package for severely or heavily indebted countries. What are the objectives of these policies, and why do you think international banks are so eager for IMF negotiations to precede their discussions with these countries? What are the economic and social costs of these programs? Explain your answer.

Question 8

Do you think a full-fledged developing-country debt crisis might reemerge in the future? If so, why and under what conditions? If not, why not?

Question 9

What has been proposed to resolve the problem of odious debt? How effective a solution do you think this will be for averting future problems involving developing-country debt?

Question 10

In what ways was the recent global financial crisis similar to past crises, and in what ways did it differ?

Question 11

Prepare a brief update on longer-term impacts of the 2008 global financial crisis. Have any of the later developments proved unexpected (or previously considered unlikely)? Where problems have lessened, do you think they could return