External Debt and Economic Sustainability
A significant amount of capital is required to develop an immature economy. Many African countries with poor natural resources have become dependent on foreign borrowings. A proper amount of debt is able to create a stable growth and economic equilibrium. Economists have sought to identify the relationships between economic development and external debt. There is a positive identification of economists between the degree of financial mediation and long-run growth, and various models have been developed to prove this (King and Levine 1993). The approach is to handle financial development as being exogenous, and the focus is generally on influencing savings allocated to investments (Bencivenga and Smith 1991). Other approaches, such as that by Greenwood and Jovanovic (1990) model financial development as the endogenous outcome of the economic growth process with a significant focus on the evolution of economic activity. Financial development also takes place in stages, which begin with bank financing and debt that causes the emergence of equity market and raises funds (Goldsmith 1969). It has also been observed that commercial and national central banks are dominant financial institutions in the developing nation. There has been a lot of research on the first stage of financing and external debt, which often leads to a sudden boom in the economy that fails to create long-term sustainability. These confine the financial development to a boom-bust pardigm based on the volume and quality provided by the banks. The increasing market capitalization has lead researchers to shift attention to the stages of financial developments towards the end stages of market activity and growth (Levine and Zervos 1996).
Macroeconomic stability only exists when there are sound fiscal and monetary policies and sustained growth. A dynamic market economy also depends on institutional foundations such as secure property rights, an effective system for enforcing contracts, and a regulatory environment that does not impose undue barriers on business activities. Financial institutions play a major role in mobilizing and allocating saving, facilitating transactions, and creating instruments for risk management. Access to the global economy is another factor of a good enabling environment because the external sector is a large source of potential markets, modern inputs, technology, and finance, as well as competitive pressure for efficiency and rising productivity. Equally important is development of the physical infrastructure to support production and trade. Finally, developing countries need to adapt and apply science and technology to attract investment, improve competitiveness, and stimulate productivity growth.
The Benefits of External Debt
Boyd and Smith’s (1996) tier analysis is based on a general equilibrium model in which developers of capital decide on one of two variant technologies: an observable technology and an unobservable technology, both of which require external finance. The unobservable technology is superior in terms of its expected yield but is vulnerable to a standard costly state verification problem; the observable technology is realised output that entails no lender cost (Diamond 1984).
The Boyd and Smith’s (1996) model predicts that economy evolves relative to the growth path, and the cost increases because there is a decrease in the relative price of capital. Because of this, firms to use observable technology rather than the unobservable technology model. Also, investments in unobservable technology are implications of debt. This in turn results that the more economically stable have more equity and therefore less debt. The model (Boyd and Smith 1996) also shows that debt finance only occurs at the lower levels of economic development, and the equity market will occur after the nation becomes sustainable and has a critical level of real per capita income.
Other literatures supports the relationship between long-run growth and market equilibrium where debt and equity function as complements of one another, in contrast to tradition beliefs that debt and equity are substitutes of one another (Maksimovic 1996). Boyd and Smith (1996) also suggest that, under the right circumstances, the economies become relatively developed, and the cost of external debt finance become too great for banks to issue debt without issuing some equity as well. The market equity then emerges as a complement to the debt market.
Incoming debt to a nation is considered a short-term capital inflow. These ‘short term capital flows’ have various forms, for the purposes of this paper, the assumption is that they include the purchase by non-residents such as foreign banks against corporate equities and natural resources, government bonds and the deposit of monetary compensation in credit to the domestic nation’s banks. Domestic financial investors have a stronger impact on the allocation of these resources than the lending non-resident financial institution, which has a different impact on domestic market risk (Hallwood and MacDonald, 1994).
Control of information and investment outcomes are different between domestic and international investors, and the result of long-term overseas asset allocation by domestic borrowers is that the investment capital has strong inflows that reduce the external assets held by domestic investors. The annual fluctuations, like foreign debt investment and domestic debt issuance relfect the liquidity (Hallwood and Macdonald 1994). The attraction to outside investors is the liquidity of the market value, and there is often some control of the ability to dispose of assets into the local markets. In the lack of stable insurance markets, liquidity becomes the best means of hedging against uncertainty.
High-risk emerging market assets with high returns carry a benefit for global portfolio investors because the risk of their overall portfolio is reduced by the low covariance between regional markets; but this does not mean that investors will stop switching between markets in attempt to maximise short-term profits. Capital movements towards ‘emerging markets’ should depend upon ‘fundamental valuation efficiency’ because this is difficult to take action towards, and relies to a great extent on the observable ctions of other investors into the domestic market, which results in misallocation of resources and savings (Tobin, 1984).
The volatility of portfolio is not because the investors are irrational or speculative, but rather it is the ability of the market flows in relation to the domestic capital markets size and stability (Hirschliefer and Riley, 1992). This is in terms of both the proportion of the domestic capital stock that is effectively ‘on the market’ and the size of the local market in relation to the international market in which the external lenders work, and the high relationship between the assets in the domestic developing country become a problem.
Economy theory shows that the greater fluctuation of the short-term capital inflows to the developing country happen because of changes in the global markets (IMF 1997). The financial markets are usually supply constrained in the developing country, and the incoming capital creates stability with the demand created by creditors instead of the indebted (Stiglitz and Weiss 1992). The reaction is that the asset demand pattern, which shows the international portfolio composition, of external investors instead of the supply of resources and natural capital by residents.
The conventional thought of the reaction of capital flows in the domestic market comes from the ‘debt cycle’. The acquisition of domestic financial assets from external sources can raise domestic fixed capital stability and provide foreign exchange, and the export potential increases. Domestic saving also rise because there is a perceived wealth. This allows the debt to be paid back through domestic surplus and increased tax yields (Stiglitz and Weiss 1992).
The accumulation balance reflects this relationship, where the national accountings can identify the domestic savings of the public and private sectors as well as investment across the two sectors. Now, there are positive changes from the cash inflows that react in the short-term asset equity of non residents, the long term investment stocks, and the level of allocated resources (Stiglitz and Weiss 1992). So when the short-term liabilities rise and capital account items are available, then variables adjust and the key is to evaluate the effect of short-term capital inflows with the determination of variable adjustments, and to understand how this impacts the domestic economy. For the debt cycle to end on a positive note for the domestic market, these adjustments have to include the increased rates of investment as capital inflows, increase productivity and transparency of trade surplus. Finally the marginal savings rates should exceed the historical averages.
The Burden of External Debt
Neo-classical economic theory shows that sustainability is the maximisation of human welfare based on a positive growth economy over time. Economists tend to oversimplify this by correlating the maximisation of human welfare with the maximisation of capital and consumption (or, supply and demand). The healthy economy therefore includes the availability of human welfare elements like food, clothing, adequate housing and health services. Economic sustainability is therefore the efficient resource allocation should maximise the economic value of commodities and consumption during various time periods. This approach does centre on the use of discount rates. Economists showed that a discount rate in external borrowing affects the generations following the national economy. (Howarth and Norgaard, 1993). The discount rate in the current market lends unnecessary weight on the current consumption environment, which creates impacts and bias against sustainable aid development. Balances of long-tern debt are therefore based on the impact of the discount rate, global trade, and the global economy changes (Cline 1992). Weak and strong sustainability tends to be poised in the neo-classical perspective where sustainability is dependant on the total value of capital and resource allocation (particularly in consumable resources) and should remain constant over time periods. In order to assess the value of capital resources against consumption, the capital depletion must be accounted for in full (El Serafy 1993). The concern comes when a nation without sustained resources and capital begins to borrow more than it is able to control, placing downward pressure on what little resources it has sustained. Alternatively, a strong sustainability approach encompasses suitability between capital and resources that complement each other and behave productively.
Inability to generate sustainability of the economy and allocate domestic savings to finance desired investment by countries is often reason for external loans. The incentive structure created by the external loans and foreign aid provisions ushers the public sector and lawmakers towards non-productivity, unethical lending and investments, and often times cause harm to the nation’s banking and legal system (Easterly 2001). Furthermore, even if the regulatory domestic bodies have incentives for more ethical behaviour, the underdeveloped and weak economies lack the ability and funding to regulate the financial systems and allocate resources properly (Easterly 2001).
External loans and aid is not a sole creator of economic, political, and social viability or stability, and is, in fact, ineffective to rectifying the state of the nation and major regulatory problems that occur and does not generate a sustainable change (Easterly 2001). The importance of external inflows is on private sector balance sheets, as noted by Easterly (2001). Capital-account cycles, their domestic financial multipliers and their reflection in asset prices are a strong constrictor of the developing nation’s growth volatility. This is because the wage and price rigidity is emphasised in the macroeconomic models of ‘neo-classical synthesis’ (Easterly 2001).
The presence of increasing returns and strong recessions will amplify losses of resources and have accumulative effects (Easterly 2001). The positive effect of this may be that there is only a once-and-for-all loss in Gross Domestic Product that is recuperated by stronger national economy (moving from underdeveloped to developed nations); adversely, the negative effect is that the long-term growth is displaced and does not generate enough GDP to maintain a domestically (and internally) supported economy (Easterly 2001). New risks also arrive to the externally funded economy. The developing nation exhibits a reliance on export strategies that lead to high commodity prices and therefore are more susceptible to fluctuations in the international trade cycles (Easterly 2001). This fluctuation occurs during the interaction between trade and capital income is given a new implication because there is now a higher degree of reliance and a significantly increased amount of exposure to the externality of market trade (Easterly 2001).
The ability of a nation to efficiently allocate resources is dependent on the extent of emerging capital market imperfections such as moral obligations and adverse selection (Watson 1993). Furthermore, the equilibrium of the loan market is strongly impacted by credit rationing (Stiglitz and Weiss 1981). Without lending however, a collapsed market will occur and banks will not be able to accurately measure associated risks, creating high rates, high cost of capital and low creditworthiness (Mankiw 1986). The constrained level of investment and funding of cash flow as well as trade sources results in a negative amount of internal investments that have a constraining impact on overall economic growth (Mankiw 1986). The high cost of capital created reduces the ability of internal borrowing and saving, which creates riskier investing and higher probability of lending default. At this point, the increased risk in lending creates a collapsible credit market regardless of the expected return on investments.
Consequently, the market equilibrium becomes very tumultuous because there is no domestic savings and investments to support the interest or prevent monetary contraction, thus the impact is on the internal credit market. The governing bodies therefore intervene in the form of tax subsidy or loan guarantees, with the implications to improve the situation and prevent market failure (Stiglitz and Wiess 1981).
The government has several roles in the supply and demand of economics. The role of government to make decisions by pushing a specific industry to produce by directly owning the industries (as we see in the oil industry) or by grants to the industry. Government can use fiscal instruments like spending and taxation) to reduce a recession or inflation and achieve equilibrium. The government can use government spending and tax. Government spending is a component of demand by introducing or removing supply. Tax controls the flow of money by removing funds from the circulated economy to the government. The ratio of tax to the supply of a product increases or decreases demand. The government also has an affect on the pricing system in supply and demand by controlling government spending in a recession. More government spending creates more jobs, which increases demand for supplied products. The opposite occurs during times of inflation. The role of government is to then decrease government spending which equalizes the excess of supply in relationship to demand. Government also controls prices in the supply and demand curve through monetary instruments that alter the supply of money into the economic structure. An example of this is the legal reserve requirements for banks. When the legal reserve is raised by government regulation during inflation, money is removed from the public and stored to prevent over consumption and reach equilibrium between supply and demand. The government also controls the interest rate through the discount rate at which banks borrow from the central bank. The government controls the supply of money into the market, and the demand for money increases or decreases as the interest rates change. If supply or demand exceed each other, the interest rate has an impact on the pricing to either increase costs or lower costs because the total demand for cash money will go up when interest rate goes down.
Stiglitz (2000) implies that the degree of financial repression and regression can hold some benefit towards return on investment until such an advanced stage in the development process occurs. The adverse selection of macroeconomic instability is then increased, where the benefit occurs when financial savings and bank investments create a stronger availability of credit (Villanueava and Mirakhor 1990). The increase in lending rate resulting from lower interest rate and stronger investments may cause less profitability because funds borrowed early on in the unstable market will in turn result in non-repayment of loans. This leads to national bankruptcy and deregulation of interest rates, thus lowered domestic savings (Mathieson 1980).
For developing countries, a large concern in this context is the lack of the domestic market for long-term stable market treasury and corporate bonds. This creates a difficulty to finance public infrastructure investments and sustainable resource allocation such as savings and bonds. It also becomes hard for banking, savings and investment firms to hedge against exchange rate changes in destabilisation of foreign currency markets; and the ability of financial intervention to react against external monetary and market shocks becomes very difficult. The unsure developing nation now has the risk of a sudden and dismantled market and value balance that can have a strong impact on its trade economy generated by the potentially disorderly financial disturbances. The paradox is that, the more funds coming into the country as ‘loans’ with no basis of national ‘savings’ (or resource allocation) the developing country can not create an account surplus, maintain monetary reserves or reduce their debt because the global imbalance of the economy prevents this (Ocampo, Kregel and Griffith-Jones 2006)
The lack of stabilised interest rates “can exacerbate the adverse incentive on banks to take risk, increased interest rates, increased macroeconomic instability and, if bank’s portfolios are concentrated on particular sectors, increased covariance in the returns to banks’ borrowers” (Brownbridge & Kirkpatrick, pp 9 1999). Because the bank industry of a nation has a strong impact on the changes of asset prices and credit expansion in collateral and interest rates, the resulting banking crisis when there is a lack of sustained domestic capital can lead to over-indebtedness and macroeconomic vulnerability. The significance of this impact is that very often, banks of developing nations are not able to adequately gauge the impact of savings and investments or monitor the use of borrowed funds. Brownbridge and Kirkpatrick (p10 1999) state that this entices banks to take on more risks and furthers market instability: “a further factor contributing to moral hazard is the erosion of bank franchise values as ceilings on deposit interest rates are lifted and barriers to entry reduced.” Another significant impacts of external loans for indebted developing nations are that the liberalisation and entry of new competitors creates a strong demand for public regulation, intervention and ethical supervision. However, the issue again is that underdeveloped countries already lack the resources to fully regulate and are consequently undermined by budget and the private sector.
Increased capital should create a more available international pool of liquidity accessible to the domestic financial system, and in turn stabilise domestic savings and investments. The actuality is that the high degree of volatile international capital penetration in combination with a delicate and constricted domestic national market subordinates the borrowing underdeveloped nation to market shocks and crisis.
The higher vulnerability of short-term capital shows that reliance on external financing has a high associated risk for the developing nation (Rodrik and Velasco, 2000). The increment and frequency of risk management strategies by multinational relationships may also create volatile financial flows. This volatility of external loans to domestic markets is transmitted to the developing country through the public sector accounts. In particular, government spending, debt service payment and interest rates are affected. The availability of financing and commodities are linked to the developing countries ability to reinforce prices within the public and private sector accounts. More…
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