Notesale: Turn your study into money

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St Edmund Hall
Foreign borrowing can be a healthy component to domestic savings, but
excessive foreign debt is a serious threat to economic growth in the long run
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Due to the deficit bias, the need for investment in infrastructures and social spending,
and inefficient tax systems subject to large amounts of tax evasion, the severe need
for revenues in Less Developed Countries (LDCs) is often met by foreign borrowing
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The thesis that I am
presenting in this essay is that I agree with the above statement, and I am going to
discuss this through examining why capital inflows occur, the ways in which
borrowing at low levels is beneficial, and how at high levels capital accumulation and
total factor productivity are negatively impacted
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Calvo, Liederman and Reinhart (1996) state that a major factor in capital inflows to
developing countries is the pattern of interest rates around the world
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These
profit opportunities were also made increasingly attractive due to the recessions seen
in the US, Japan and much of Europe in the 1990s, leading the trend towards
international diversification of investments in major financial centres, and growing
integration of world capital markets
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It is clear that foreign capital can finance investment and stimulate economic growth,
raising the standard of living in the developing world
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Social services and infrastructure can be built, raising
capital accumulation and Total factor productivity
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However borrowing also induces less desirable macroeconomic effects in itself
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2-0
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While many OECD
countries have solved this issue through Central Bank independence, Cuckierman et
al (1992) have found no evidence of correlation between formal indexes of Central
Bank independence and inflation rates
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A government is
solvent if the projected present value of future repayment is at least equal to the
current stock of debt (PV[ΔM - PD,i] ≥D0), however this condition is not particularly
restrictive – the level of debt can increase over time without necessarily violating the
condition – but implies that high levels of deficits and debts can be considered
sustainable if appropriate fiscal conditions are expected in the future
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When external debt grows large, investors lower their
expectations of returns in anticipation of the higher and progressively more
distortionary taxes that will be needed to repay the debt, so discouraging domestic and
foreign investment and slowing capital stock accumulation
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As individual investors internalize the tax
effect of the debt, the fear of appropriation will reduce the expected after tax-rate of it
is return on capital
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The period of low growth can be significantly extended due to capital
flight, which can cause a financial crisis
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Cohen (1995) however states that the fact that the face value of the debt exceeds what
creditors actually expect to be repaid is not sufficient to conclude that investment will
be disincentivised
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They can then promise more generous
rescheduling in the future if the country invests more
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This problem is exacerbated by
the presence of official creditors such as the IMF, who increase the bargaining power
of private creditors and complicate negotiations with debtors
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A second point in the effect of debt on capital accumulation is that in heavily indebted
countries investors hold back due to uncertainties about what portion of the debt will
actually be serviced with the country’s own resources
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High debt levels can also constrain growth through the channel of total factor
productivity
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Poorer policy environment will affect the efficiency of

St Edmund Hall
investment and productivity, and uncertainties and instabilities related to debt
overhang are likely to hinder incentives to improve technology or to use resources
efficiently
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Patillo, Poirson and Ricci (2004) find that the negative impact of high debt on growth
appears to operate through a strong negative effect in both the channels – capital
accumulation and total factor productivity – as studied through 445 observations for
61 countries over the period of 1969-1998
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The average effect becomes negative at a threshold of 160-170%
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It is
not clear that the thresholds and marginal effects out to be identical across very
different countries as these empirical results suggest
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Bulow and Rugoff (1990), Warner
(1993) and Easterly (2001) all take this view, in which over-valued exchange rates
negatively affect competitiveness and hence the ability of the private sector to earn
the foreign exchange needed to pay external creditors
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This was supposedly seen in the worldwide
slowdown in growth after 1975 which contributed to debt crises of middle income
countries in the 1980s, and Heavily Indebted Poor Countries (HIPCs) in the 1980s
and 1990s
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These have
been proved empirically, and as a result I believe that excessive foreign debt is a
serious threat to economic growth in the long run
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Agenor ”The Economics of Adjustment and Growth” Harvard University
Press
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3,9,15,16

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William R
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E
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0(1)
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, H
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Ricci, (2004), What Are the Channels Through
Which External Debt Affects Growth? IMF Working Paper
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Cambridge University
Press
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6, 7, 8

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