Balance of Payments, Aid, and Foreign Investment

bundet

P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 526 Part Four. The Macroeconomics and International Economics of Development BOX 15-1. THE HAWALA SYSTEM Stateless and nomadic peoples and those living amid war often design alternative systems to those of banks, credit cards, and travelers’ checks. According to Peter Little (2003:142) In the Somali borderlands, conﬁdence in the local currency facilitates credit and ﬁnancial transfers, critical components of commerce because of the risks associated with [traders and herders] carrying large amounts of cash. While much of the livestock trade is calculated in SoSh [the Somalia shilling issued in the 1980s] and ﬁnal payments are made in SoSh or US dollars, the actual handling of cash in large transactions is minimal. Somali border traders … can take their earnings to Nairobi, convert them to dollars, and then “wire” them back to money houses in Somalia, where they can be picked up by associates. This informal hawala system avoids the carrying of large amounts of cash across the border. Informal money houses and middlemen, important in long-distance trade involving livestock, mediate credit in a system that requires considerable trust to operate. The Somali shilling, because of its relative stability, facilitated border trade in livestock and other commodities in a weak state that lacked a central bank (Little 2003:142, 145). Unfortunately for many Somalis, the largest hawala bank, al Barakat, was abruptly closed in November 2001 by a U.S.-led initiative that claimed the bank laun- dered funds for al-Qaida. Thus, what had evolved as a viable institution for trans- fers following the collapse of Somalia’s ﬁnance sector was closed to thousands of Somali families dependent on it in the region and around the world (Little 2003: 143). The weaknesses of banks and other ﬁnancial institutions impose substantial trans- actions costs on migrants who send remittances. The average cost of these transfers (exchange-rate commissions and transfers fees) are 12.8 percent in Cuba, 12.6 per- cent in Colombia, 10.7 percent in Haiti, and 9.1 percent in Mexico, an astronomical sum compared with transfers among DCs. Many U.S. banks recognize matriculas consulares , identity cards for legal or illegal residents with Mexican citizenship, as identiﬁcation for opening bank accounts (World Bank 2003f:165–166). The exorbitant transfer cost has increased the use of informal channels, such as the hawala (“transfer” in Arabic) (Little 2003:143; World Bank 2003f:173). However, in an era of concern about money laundering by terrorists, the hawala option has been increasingly cut off, as Box 15-1 indicates. PRIVATE INVESTMENT AND MULTINATIONAL CORPORATIONS As real aid to less-developed countries fell during the 1990s, foreign direct investment (FDI), at 74 percent in 2002, comprised an increasing portion of total resource ﬂows to developing countries (Figure 15-1). Private FDI, a source for ﬁnancing the balance P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 527 45 40 35 30 25 20 15 10 5 0 1998 1982 A ll c o u ntries C anada M e x i c o C hina Other A sia FIGURE 15-8. Exports of U.S. Afﬁliates as a Share of Total Exports (in percent). Note: Exports from U.S. afﬁliates in all countries show no rise in the share of sales because of declines in the export shares in primary production. Source: World Bank 2000f:58. on goods and services deﬁcit, consists of portfolio investment , in which the investor has no control over operations, and direct investment , which entails managing the operations. In the 19th century, Western European investment in the young growing debtor nations, the United States and Canada, was primarily portfolio investment, such as securities. Today, DC investment in LDCs is mostly private direct investment. Multinational corporations (MNCs), business ﬁrms with a parent company in one country and subsidiary operations in other countries, are responsible for much of this direct investment. MNC intraﬁrm trade is a large proportion of international trade. In 1999, 36 per- cent of U.S. exports were intraﬁrm exports, whereas in Japan 31 percent of exports were intraﬁrm, for both countries an increase over 1990’s percentage. Intraﬁrm trade in services became steadily more important during the last quarter of the 20th century. In addition, LDCs boosted exports by participating in global production networks dominated by DCs such as the United States and Japan. Exports of U.S. afﬁliates as a percentage of China’s exports were 36 percent in 1998. Figure 15-8 shows U.S. afﬁliate percentages in other Asian countries, Mexico, Canada, and all countries with U.S. afﬁliates in 1982 and 1998. At the turn of the 21st century, the global economy was dominated by MNCs from the United States, European Union, and Japan. DCs comprised 71 percent of foreign direct investment (FDI) inﬂows, 75 percent of FDI outﬂows, and a large share of the international trade. But emerging economies such as Taiwan, South Korea, Singapore, China, India, and Brazil are beginning to be a factor in foreign investment (D’Costa 2003:3l; Table 15-3). Moreover, as Figure 15-9 shows, in 2000, 56 percent of the FDI in LDCs is from high-income OECD countries compared to 35 percent from other LDCs, and 9 percent from high-income non-OECD countries. H igh - in c ome non - O ECD /total FD I North - So u th FD I/total FDI So u th - So u th FD I/total FDI FIGURE 15-9. Share of South–South FDI in Total FDI. Source: World Bank 2003f:124. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 528 Part Four. The Macroeconomics and International Economics of Development TABLE 15-3. Outward FDI Flows, a by Geographical Destination, 1999–2001 (billions of dollars and percentage distribution) Value in billion dollars Percentage distribution Average Average Region/economy 1999–2000 2001 1999–2000 2001 Developed countries 924.2 470.1 83.7 74.6 Western Europe 640.9 259.7 58.0 41.2 European Union 589.4 236.6 53.4 37.5 Other Western Europe 50.9 24.1 4.6 3.8 Unspeciﬁed Western Europe 0.6 − 1.0 0.1 − 0.2 North America 256.2 197.3 23.2 31.3 Other developed countries 25.0 9.1 2.3 1.4 Unspeciﬁed developed countries 2.2 3.9 0.2 0.6 Developing economies 129.2 115.2 11.7 18.3 Africa 6.8 8.5 0.6 1.3 North Africa 0.5 1.8 0.0 0.3 Other Africa 5.0 6.3 0.5 1.0 Unspeciﬁed Africa 1.3 0.4 0.1 0.1 Latin America and the Caribbean 84.7 69.1 7.7 11.0 South America 39.5 20.3 3.6 3.2 Other Latin America and Caribbean 36.4 38.0 3.3 6.0 Unspeciﬁed Latin America and Caribbean 8.8 10.9 0.8 1.7 Asia 33.9 36.5 3.1 5.8 West Asia 0.8 2.8 0.1 0.4 Central Asia 1.0 0.1 0.1 0.0 South, East, and South-East Asia 31.0 32.8 2.8 5.2 Unspeciﬁed Asia 1.1 0.8 0.1 0.1 The Paciﬁc 1.5 0.8 0.1 0.1 Unspeciﬁed developing countries 2.4 0.3 0.2 0.1 Central and Eastern Europe 18.0 18.6 1.6 3.0 Unspeciﬁed 32.7 26.3 3.0 4.2 Total world 1,104.1 630.3 100.0 100.0 May not add up to totals because of rounding. a Totals for developed countries are based on data for the following countries: Australia, Austria, Belgium and Luxembourg, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, and United States. Source: UNCTAD 2003:9. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 529 The United States accounted for 52 percent of the world’s stock of outward foreign direct investment (FDI) capital in 1971, 40 percent in 1983, 25 percent in 1993, and 16 percent in 2001. DCs comprised 97 percent of world FDI capital stock in 1983 and 93 percent in 1993, but fell to 75 percent in 2001. The United States was the leading source of outward FDI from 1971 to 2001 although the European Union, with 38 percent, had more than twice the US’s 2001 ﬁgure. The leading countries of the South with FDI stock included DCs Singapore, Taiwan, South Korea, and Hong Kong, in addition to South Africa, India, Brazil, Argentina, Colombia, Peru, the Philippines, and the OPEC countries (Bergsten, Horst, and Moran 1981:267–95; Streeten 1981:308–15; Dunning 1988:28–29; UNCTAD 1994; UNCTAD 2003:6–9). The United States had both the largest inward (Table 15-4) and outward ﬂows of foreign direct investment in 2001. 10 When Hong Kong is included, China ranked second in 2001 in inward ﬂows (or ﬁrst in LDC inﬂows). Although some FDI ﬂowing to China is recycled domestic investment (explained in Chapter 19), even if this were subtracted, China’s FDI inﬂows would rank ﬁrst among LDCs. The world’s potentially largest market and low-cost labor-intensive production in China, which has become the world’s major industrial workshop, attracted many MNCs. Most of the world’s business community believed that no one could afford to ignore the enormous investment opportunities in China. For many an MNC, investment in China represented an effort to get its “foot in the door.” But China, a low-cost source, is a hard bargainer, frequently demanding total access to foreign technology in exchange for access to its market (Kranhold 2004:A1). Still, China’s FDI growth for the ﬁrst two decades of the 21st century will depend largely on its political stability, the consistency of its economic policies, its macroeconomic management, and its integration into the world economy (UNCTAD 1994b:14–68). Mexico and Brazil were other leading FDI hosts in developing countries. If we use UNCTAD deﬁnitions of LDCs, which include Singapore, Republic of Korea, and Taiwan, and if Hong Kong is combined with China, the top 10 FDI recipients among developing economies received 73 percent of inward FDI in 2001. UNC- TAD (2002b:215) states that private capital ﬂows have been concentrated in a few countries. Africa, where the risk premium is high, received only 19 percent. Most of the leading African recipients – Angola, Nigeria, Algeria, Chad, Tunisia, South Africa, Sudan, Egypt, Morocco, and Mozambique – received large amounts of FDI in minerals or petroleum (UNCTAD 2003:7–13, 34). The World Bank (1997a:2) states that “participation in the global production networks established by multinational enterprises provides developing countries with new means to enhance their economic performance by accessing global know-how and expanding their integration into world markets.” Indeed, net private capital ﬂows to LDCs were $168 billion or 2.8 percent of their GNI in 2001, a fall from 10 The drop in inﬂows to the United States reﬂected large repayments of loans by foreign afﬁliates in the United States to their parent companies and reductions in ﬁnancing mergers and acquisitions in the United States. Much of the inﬂow to Luxembourg, separated from Belgium for the ﬁrst time in 2002, was driven by tax advantages rather than productivity (UNCTAD 2003:6–8, 31). P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 530 Part Four. The Macroeconomics and International Economics of Development TABLE 15-4. FDI Inﬂows to Major Economies, 2001 and 2002 (billions of dollars) Host region/economy 2001 2002 World 823.8 651.2 Developed countries 589.4 460.3 European Union 389.4 374.4 France 55.2 51.5 Germany 33.9 38.0 Luxembourg − 125.6 United Kingdom 62.0 24.9 Other EU 238.3 134.4 United States 144.0 30.0 Other 56.0 55.9 Developing economies 209.4 162.1 Africa 18.8 11.0 Algeria 1.2 1.1 Angola 2.1 1.3 Nigeria 1.1 1.3 South Africa 6.8 0.8 Other Africa 7.6 6.5 Latin America and the Caribbean 83.7 56.0 Argentina 3.2 1.0 Brazil 22.5 16.6 Mexico 25.3 13.6 Other Latin America 32.7 24.8 Asia and the Paciﬁc 106.9 95.1 China 46.8 52.7 Hong Kong, China 23.8 13.7 India 3.4 3.4 Korea, Republic of 3.5 2.0 Malaysia 0.6 3.2 Philippines 1.0 1.1 Singapore 10.9 7.7 Taiwan Province of China 4.1 1.4 Thailand 3.8 1.1 Other Asia and Paciﬁc 9.0 8.8 Transitional economies 25.0 28.7 Central and Eastern Europe 25.0 28.7 Czech Republic 5.6 9.3 Poland 5.7 4.1 Russian Federation 2.5 2.4 Other C. & E. Europe 11.2 12.9 May not add up to totals because of rounding. Categories of developed, developing, and transitional economies may vary from those in this book. Source: UNCTAD 2003:7. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 531 this percentage in 1990. This percentage fell even further for low-income countries, many with low credit ratings during this period, a continuation of a fall that began in the early 1980s (World Bank 2003h:16, 332; FitzGerald 2002:62–84). In addition, private capital ﬂows are highly volatile, especially in countries that have liberalized their ﬁnancial markets. After the 1997–98 Asian crisis, for example, private capital ﬂows to LDCs fell substantially. Although subject to substantial ﬂuctuations, about half of private capital ﬂows to LDCs in the 1990s were loans, which contribute to future debt service, and portfo- lio investments, which are subject to reverse capital ﬂows (World Bank 2002e:354; UNCTAD 2003d:4). FDI does not generate debt servicing or capital outﬂows, and potentially can ﬁnance a savings or balance of payments deﬁcit, bring about a trans- fer of technology and innovative methods of increasing productivity, ﬁll part of the shortage of high-level skills, provide training for domestic managers and technicians, generate tax revenue from income and corporate proﬁts tax, and complement local entrepreneurship by subcontracting to ancillary industries, component makers, or repair shops, or by creating forward and backward linkages. Investment inﬂows as a percentage of gross ﬁxed capital investment in Africa were 9 percent in 2002. However, although annual FDI ﬂows to least developed countries increased by 65 percent from 1989 to 1994, and tripled from 1989 to 2001 (Fig- ure 15-10) the least-developed countries’ share of developing-country inﬂows was only 0.6 per cent in 2001. Most of these ﬂows were to African mineral and petroleum countries (UNCTAD 2002c:49, 74, 77). Moreover, low-income countries (LICs) com- prised only 30 percent of the $171 billion FDI ﬂows to developing countries of 2001, and India took a lion’s share of LIC’s FDI (World Bank 2003e:87; World Bank 2003h: 331–332). 11 The share of FDI ﬂows in 1998–2000 gross domestic capital formation was 7 percent for LLDCs and 13 percent for all other developing countries. According to UNCTAD (2002c:73–78), 17 of the 25 LLDCs for which indexes were constructed were underperformers, 1986–2001, in attracting FDI ﬂows. Developing countries, particularly LLDCs, need policies to increase FDI and other external resources. In 1988, the World Bank established the Multilateral Investment Guarantee Agency (MIGA) to help developing countries attract foreign investment. MIGA provides investors with marketing services, legal advise, and guarantees against noncommercial risk, such as expropriation and war (Aguilar 1997:10). By 2001, 41 least-developed countries had concluded bilateral investment treaties (BITs) with other countries for the protection and promotion of foreign investment, and 33 had entered into double taxation treaties to avoid taxation in both LLDC and the headquarters’ country. FDI plays a role not only in ﬁnance but also in skills, technology, and knowledge needed to spur economic growth (ibid., pp. 78–79). 11 Ndikumana (2001) contends that reports of a “surge” in Africa’s FDI is an illusion. Africa’s share of FDI inﬂows to LDCs fell from 10.5 percent in 1981–89 to 4.3 percent in 1999. Reasons for this fall were a weak macroeconomic environment, underdeveloped ﬁnancial system (including weak regulation and supervision), and high country risk from high transactions cost from administrative inefﬁciency and psychocultural distance. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 532 Part Four. The Macroeconomics and International Economics of Development FIGURE 15-10. FDI Inﬂows and ODA Flows to LLDCs, 1985–2001 (billions of dollars) . Source: UNCTAD 2002d:77. Although ofﬁcial development assistance comprised the largest component of exter- nal resources for LLDCs, it declined relatively and absolutely, 1995 to 2000 (see Figure 15-10). Tanzania, an LLDC, provided an enabling framework for FDI in the late 1980s and early 1990s, by making the transition to a market economy, undertaking market reforms (including enacting a mining act more favorable to FDI), and beginning a privatization program for inefﬁcient state enterprises. During 1995–2000, Tanzania received $1 billion FDI, much in gold mining, compared to only $90 million during 1989–94. Mining served as an engine of growth, helping to increase gold exports and to modernize the banking industry. Foreign investors have helped restructure privatized enterprises, boosting technology, skills, and competitiveness. In addition, from the early to late 1990s, FDI’s contribution to the balance of payments changed from negative to positive (UNCTAD 2002c:75). Similar to Tanzania, there is a possibility of attracting FDI to LLDCs and low- income countries, not just to those with potentially large markets, such as China and India; with nonresident nationals, as China or India; with resident nationals man- aging cross-border investments, as in Malaysia, Mozambique, South Africa, or East Africa (FitzGerald 2002:71); or with extractive industries, such as Nigeria or Angola. Vietnam introduced FDI legislation in 1987–88, which, together with the lifting of U.S. economic sanctions in 1994, increased FDI inﬂows from $8 million in 1988 to $150 million in 1995. Bangladesh’s FDI reforms in 1991, which facilitated the estab- lishment of foreign-owned subsidiaries, increased inﬂows from just a trickle in the 1980s to $125 million in 1995. Ghana, as a result of Ashanti goldﬁeld privatization, increased annual FDI inﬂows 17-fold from a $11.7 million average during 1986–92 to an average of $201 million in 1993–95 (ODI 1997:2). Even Cambodia, which created a legal framework and the necessary institutions to promote FDI after 1993, increased its FDI capital inﬂows from virtually nothing in 1990 to $656 million in 1996 (UNCTAD 1997a:54, 316). P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 533 Since the mid-1980s, with falling trade, transport, and communication barriers, multinational corporations (MNCs) have increased their international outsourcing, importing components from low-cost production locations abroad and exporting to overseas assembly or processing locations. As an example, following the rise of the yen after 1985, Japan’s major electronics manufacturers outsourced assembly and other ﬁnal stages of output to Asian countries (World Bank 1997i:42–43). Asian NICs and ASEAN countries were a part of Japanese companies’ borderless economic system of trade and investment. These companies used a ﬂying-geese pattern, with Japan at the lead, and Asian emerging nations forming the “V” behind. Chapter 17 discusses both Japanese and U.S. global production networks. Developing countries need to undertake major institutional changes (see Chap- ter 4), not only to facilitate foreign and domestic investment but to provide the scaf- folding for other economic policies that increase a country’s attractiveness for foreign private domestic capital ﬂows. With changes in institutions, a number of low-income countries could begin participating in the new international division of labor cre- ated by outsourcing by high-income OECD countries. But this ﬂying-geese pattern may also apply to non-OECD leader countries. ECA (1989) estimates that, dur- ing the 1980s, Southern African Development Community (SADC) countries other than South Africa lost one-fourth of their GDP from South Africa’s destabilization. However, since 1994, a democratic and prosperous South Africa should provide the economic leadership to spur SADC’s economic development. South Africa, with its trade and FDI (including those by MNCs in the country), could serve as a “growth pole” for other SADC members of the region – Angola, Botswana, Lesotho, Malawi, Mauritius, Mozambique, Namibia, Swaziland, Tanzania, Zambia, and Zimbabwe (UNCTAD 1997b:64–66). Of course, participating in this global production sharing has its beneﬁts and costs, as in the cases of Malaysia and Thailand, discussed in Chapter 17, and also discussed later when we look at the beneﬁts and costs of MNCs. THE BENEFITS AND COSTS OF MULTINATIONAL CORPORATIONS Some LDC governments are ambivalent, or even hostile, toward MNCs. To be sure, these corporations bring in capital, new technology, management skills, new prod- ucts, and increased efﬁciency and income; however, MNCs usually seek to maximize the proﬁts of the parent company, rather than the subsidiaries’. Surely the main rea- son for LDCs soliciting MNC investment and other foreign direct investment is their contribution to technology transfer. 12 However, it may be in the interest of the parent company to limit the transfer of technology and industrial secrets to local personnel of the subsidiary, to restrict its exports, to force it to purchase intermediate parts and capital goods from the parent, and to set intraﬁrm (but international) transfer prices to shift taxes from the host country. Still, during the last decade or so, some MNCs have concentrated increasing research and development in afﬁliates, even in LDCs. 12 Javorcik (2004:605–627) ﬁnds positive productivity spillovers from FDI from foreign afﬁliates to their local suppliers (that is, backward linkages) but only with partially owned foreign projects. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 534 Part Four. The Macroeconomics and International Economics of Development For example, in the 1990s, when U.S., Japanese, and E.U. MNC afﬁliates became more integrated into parent companies’ highly nuanced value added ladder, MNCs located more research and development (R&D) in their afﬁliates. Most foreign investment is from large corporations. The largest MNCs, with hun- dreds of branches and afﬁliates throughout the world, have an output comparable to the LDC with which they bargain. ExxonMobile, Shell, BP, General Motors, Ford, Toyota, Hitachi, Matsushita, Siemens, and General Electric each have an annual value added exceeding that of most third-world countries (Table 15-5). Thus, for instance, General Motors would not negotiate investment in Bangladesh or ExxonMobile in Nigeria as an inferior party but as roughly an equal in economic power and size. 13 Furthermore, MNCs are increasingly footloose, shifting investments from country to another as tax rates, wages, and other costs change (Barnet and Cavanagh 1994). MNCs are important actors on the international scene. UNCTAD estimates that the value added of the world’s top 100 ﬁrms accounted for 4.3 percent of world GDP in 2000 (UNCTAD 2002:91) and that MNC intraﬁrm trade was one-third of inter- national trade (UNCTAD 1994b). Four-ﬁfths of Africa’s 1983 commodity trade was handled by MNCs. Thirty-eight percent of total U.S. imports in 1977 consisted of intraﬁrm transactions by MNCs based in the United States. Over one-third of these transactions were from LDCs. Moreover, MNCs play an important role in LDC manufacturing exports, responsible for 20 percent of Latin America’s manufactured exports. Indeed, U.S. afﬁliates alone accounted for 7.2 percent of 1977 LDC manu- facturing exports, 35.7 percent of Mexico’s, and 15.2 percent in Brazil, but only 1.5 percent in South Korea (UNCTAD Seminar Program 1978; Streeten 1981:308–315; Economic Commission for Africa 1983a; UNCTAD 1985:3–8; Blomstrom, Kraus, and Lipsey 1988). The markets MNCs operate in are often international oligopolies with compe- tition among few sellers whose pricing decisions are interdependent. International economists contend that large corporations invest overseas because of international imperfections in the market for goods, resources, or technology. The MNCs beneﬁt from monopoly advantages, such as patents, technical knowledge, superior manage- rial and marketing skills, better access to capital markets, economies of large-scale production, and economies of vertical integration (that is, cost savings from decision coordination between a producing unit and its upstream suppliers and its down- stream buyers). An example of vertical integration is from crude petroleum marketing backward to its drilling and forward to consumer markets for its reﬁned products. UNCTAD (1993:5) argues, however, that in the 1990s, with substantial improve- ments in communication and information technologies, MNCs have moved to even more complex integration, coordinating “a growing number of activities in a wider array of locations.” Multinationals are increasingly establishing stand-alone afﬁli- ates, linked by ownership to the parent but otherwise operating largely as independent 13 Table 15-5 subtracts purchases of inputs from other ﬁrms from, for example, General Motor’s pro- duction to get value added, to avoid double-counting the production of inputs supplied by one ﬁrm to another. This makes the ﬁgure for GM comparable to Bangladesh’s GDP. The table’s notes indicate the adjustment made to sales to obtain value added, an adjustment that, at best, indicates a rough comparability between MNCs and nation-states. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 535 TABLE 15-5. Ranking of Developing (Low- and Middle-Income) Countries and Multinational Corporations According to Value Added in 2000 a ($ billions) 1. China 1,080 2. Brazil 595 3. Mexico 575 4. India 457 5. Argentina 285 6. Russian Federation 251 7. Turkey 200 8. Saudi Arabia 173 9. Poland 158 10. Indonesia 153 11. South Africa 126 12. Thailand 122 13. Venezuela 120 14. Iran, Islamic Rep. of 105 15. Egypt 99 16. Malaysia 90 17. Colombia 81 18. Philippines 75 19. Chile 71 20. Exxon Mobile b 63 21. Pakistan 62 22. General Motors b 56 23. Peru 53 24. Algeria 53 25. Bangladesh 47 26. Hungary 46 27. Ford Motor 44 28. Daimler Chrysler 42 29. Nigeria 41 30. General Electric b 39 31. Toyota Motor b 38 32. Kuwait 38 33. Romania 37 34. Royal Dutch/Shell 36 35. Morocco 33 36. Ukraine 32 37. Siemens 32 38. Viet Nam 31 39. Libyan Arab Jamahiriya 31 40. BP 30 41. Wal-Mart Stores c 30 42. IBM b 27 43. Volkswagen 24 44. Cuba 24 (continued) P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 536 Part Four. The Macroeconomics and International Economics of Development TABLE 15-5 (continued) 45. Hitachi b 24 46. Total FinaElf 23 47. Verizon Communications d 23 48. Matsushita Electric Industrial b 22 49. Mitsui & Company c 20 50. E. On 20 51. Oman 20 52. Sony b 20 53. Mitsubishi c 20 54. Uruguay 20 55. Dominican Republic 20 56. Tunisia 19 57. Philip Morris b 19 58. Slovakia 19 59. Croatia 19 60. Guatemala 19 61. SBC Communications d 19 62. Itochu c 18 63. Kazakhstan 18 64. Honda Motor b 18 65. Eni 18 66. Nissan Motor b 18 67. Toshiba b 17 68. Syrian Arab Republic 17 69. GlaxoSmithKline 17 70. BT 17 Note: Thirty high-income countries (see cover) were omitted from the table. a GDP for countries and value added for MNCs. Value-added is deﬁned as the sum of salaries, pretax proﬁts, and depreciation and amortization. b Value-added is estimated by applying the 30 percent share of value- added in the total sales, 2000, of manufacturers for which the data were available. c Value-added is estimated by applying the 16 percent share of value- added in the total sales, 2000, of trading companies for which the data on value-added were available. d Value-added is estimated by applying the 37 percent share of value- added in the total sales, 2000, of other tertiary companies for which the data on value-added were available. Source: UNCTAD 2002c:90–91. concerns within the host economy. These afﬁliates arrange their own subcontractors, suppliers, and marketing, with some even located in third countries. From 1988 to 1992, LDCs, under pressure by creditors to privatize public enter- prises, sold 17 percent of their medium-sized and large state-owned enterprises to foreign direct investors. In Eastern Europe and the former Soviet Union, 1988 to P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 537 1992, FDI from privatizing state-owned enterprises comprised 67 percent of total FDI inﬂows to that region (UNCTAD 1994b:26). Additionally, in some industries, control over global marketing and ﬁnancing still gives MNCs much power in determining the supply and price of LDC primary exports. For example, three conglomerates account for 70–75 percent of the global banana market; six corporations, 70 percent of cocoa trade; and six MNCs, 85–90 percent of leaf tobacco trade (Economic Commission for Africa 1983a). Yet, ironically in some instances, MNCs may increase competition because their intraﬁrm transactions break down barriers to free trade and factor movement between countries. By contrast, once MNCs are established in an economy, they may exploit their monopolistic advantages and enhance concentration. Thus, MNCs, which accounted for 62 percent of manufacturing’s capital stock in Nigeria in 1965, contributed to high rates of industrial concentration. Yet a subsidiary’s production that dominates a LDC industry may be only a fraction of the parent company’s output and peripheral to the MNC’s decision-making process (Kindleberger 1974:267–285; Nafziger 1977:55–60). You may have already sensed that leaders in LDCs do not agree on whether MNCs are beneﬁcial or not. Some emphasize that MNCs provide scarce capital and advanced technology essential for rapid growth. Others believe such dependence for capital and technology hampers development. In the next two sections, we summarize the beneﬁts and costs of MNCs in less-developed countries. 14 The beneﬁts of MNCs. MNCs can help the developing country to 1. Finance a savings gap or balance of payments deﬁcit. 2. Acquire a specialized good or service essential for domestic production (for exam- ple, an underwater engineering system for offshore oil drilling or computer capa- bility for analyzing the strength and weight of a dam’s components). 3. Obtain foreign technology and innovative methods of increasing productivity. 4. Generate appropriate technology by adapting existing processes or by means of a new invention. 5. Fill part of the shortage in management and entrepreneurship. 6. Complement local entrepreneurship by subcontracting to ancillary industries, component makers, or repair shops; or by creating forward and backward link- ages. 7. Provide contacts with overseas banks, markets, and supply sources that would otherwise remain unknown. 8. Train domestic managers and technicians. 9. Employ domestic labor, especially in skilled jobs. 10. Generate tax revenue from income and corporate proﬁts taxes. 11. Enhance efﬁciency by removing impediments to free trade and factor movement. 12. Increase national income through increased specialization and economies of scale. 14 Sources for these two sections are M ¨ uller (1979:151–178); Streeten (1973:1–14); Lall (1974:41–48); and Bufﬁe (1993:639–667). P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 538 Part Four. The Macroeconomics and International Economics of Development The costs of MNCs. Some economists and third-world policy makers have questioned whether MNC beneﬁts exceed costs. These critics charge that MNCs have a negative effect on the developing country because they 1. Increase the LDC’s technological dependence on foreign sources, resulting in less technological innovation by local workers. 2. Limit the transfer of patents, industrial secrets, and other technical knowledge to the subsidiary, which may be viewed as a potential rival (Adikibi 1988:511– 526). For example, Coca-Cola left India in 1977 rather than share its secret formula with local interests (although in 1988–89 it reentered India, but without sharing its formula, to forestall dominance by Pepsi Cola’s minority-owned joint venture). 3. Enhance industrial and technological concentration. 4. Hamper local entrepreneurship and investment in infant industries. 5. Introduce inappropriate products, technology, and consumption patterns (see Nafziger, 2006b:Box 15-2, “Infant Feeding and the Multinationals”). 6. Increase unemployment rates from unsuitable technology (see Chapter 9). 7. Exacerbate income inequalities by generating jobs and patronage and producing goods that primarily beneﬁt the richest 20 percent of the population. 8. Restrict subsidiary exports when they undercut the market of the parent com- pany. 9. Understate tax liabilities by overstating investment costs, overpricing inputs transferred from another subsidiary, and underpricing outputs sold within the MNC to another country. 10. Distort intraﬁrm transfer prices to transfer funds extralegally or to circumvent foreign exchange controls. 11. Require the subsidiary to purchase inputs from the parent company rather than from domestic ﬁrms. 12. Repatriate large amounts of funds – proﬁts, royalties, and managerial and service fees – that contribute to balance of payments deﬁcits in the years after the initial capital inﬂow. 13. Inﬂuence government policy in an unfavorable direction (for example, excessive protection, tax concessions, subsidies, infrastructure, and provision of factory sites). 14. Increase foreign intervention in the domestic political process. 15. Divert local, skilled personnel from domestic entrepreneurship or government service. 16. Raise a large percentage of their capital from local funds having a high oppor- tunity cost. On the last point, Ronald M ¨ uller’s (1979:151–178) evidence from Latin Amer- ica indicated that MNCs contribute only 17 percent, and local sources 83 percent, of the ﬁnancial capital. However, M ¨ uller includes as local capital the subsidiary’s reinvested earnings and depreciation allowances. If this source is excluded, local ﬁnancing accounts for 59 percent of total capital. Still, if the ﬁgure is representative P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 539 of developing countries as a whole, MNCs contribute less than generally believed. Moreover, even if local individuals and ﬁnancial institutions contribute only 20 to 30 percent, this amount represents substantial funds that invested elsewhere might better meet the country’s social priorities. Southern Africa illustrates MNC cost. Between 1960 and 1985, almost half the Western MNC investment in Africa was in the Republic of South Africa, supporting not only apartheid there but also harming the neighboring countries’ development. The MNCs and the Pretoria government viewed South Africa as the core for their expanding activities throughout other parts of southern Africa, which provided labor, a market, and raw materials. The MNCs with subsidiaries also in South Africa’s neighboring countries dominated their banking systems, invested much of these coun- tries’ ﬁnancial capital in South Africa, shipped raw materials for processing from them to South Africa, and neglected their manufacturing and (sometimes) mining industries. These neighbors bought capital goods, some consumer goods, and even foodstuffs from South African MNCs. Until the 1980s, the international copper com- panies in Zambia, Zaire, Botswana, and Namibia built most fabricating factories in South Africa or the West (Seidman and Makgetla 1980). The MNCs and LDC economic interests. The MNC beneﬁts and costs vary among classes and interest groups within a LDC population. Sometimes political elites wel- come a MNC because it beneﬁts them through rakeoffs on its contract, sales of inputs and services, jobs for clients, and positions on the boards of directors (even though the ﬁrm harms the interests of most of the population). However, as political power is dispersed, elites may have to represent a more general public interest. Since the early 1970s, there has been a shift in bargaining power away from the MNCs to third-world governments, which have increased their technical and economic expertise and added alternative sources of capital and technology. An increasing share of MNC investment is in joint ventures with LDC government or business. And LDCs have appropriated more of the monopoly rents from public utilities and mineral production. In the 1970s, the most visible change was the shift in the ownership of OPEC oil concessions from the international oil companies to OPEC member governments (see Chapter 13). Moreover, as a result of increasing LDC restrictions, some of the MNC role has shifted from equity investment, capital ownership, and managerial control of overseas facilities to the sale of technology, management services, and marketing. As LDCs become more selective in admitting MNCs, and more effective at bargaining, they increase the beneﬁts and reduce the costs of MNCs (Streeten 1981:308–315). Some economists, however, would argue that, since the mid-1980s, the bargaining power has shifted back somewhat to MNCs. Under IMF stabilization loans and IMF- World Bank adjustment loans, LDCs have faced pressures to privatize and open their economies to foreign capital investment, policies that provide more opportunities for DC-based multinational companies. Alternatives to MNC technology transfer. The LDCs can receive technology from MNCs without their sole ownership. Joint MNC–local country ventures can help P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 540 Part Four. The Macroeconomics and International Economics of Development LDCs learn by doing. Yet frequent contractual limits on transferring patents, industrial secrets, and other technical knowledge to the subsidiary, which may be viewed as a potential rival, may hamper learning beneﬁts. Turnkey projects , in which foreigners for a price provide inputs and technology, build plant and equipment, and assemble the production line so that locals can initiate production at the “turn of a key,” are usually more expensive and rarely proﬁtable in LDCs (which usually lack an adequate industrial infrastructure). Other arrangements include management con- tracts, buying or licensing technology, or (more cheaply) buying machinery in which knowledge is embodied. The late-19th-century Japanese government, which received no foreign aid, introduced innovations by buying foreign technology or hiring foreign experts directly. More recently, in the 1980s, the Chinese government-owned Jialing Machinery Factory in Chongqing improved the engineering of its motorcycles sub- stantially by buying technical advice, machines, and parts, and licensing technology from Japan’s Honda Motor Company. Additionally, nonmarket sources of foreign knowledge include imitation, trade journals, and technical and scientiﬁc exchange, as well as feedback from foreign buyers or users of exports – all virtually costless (Nafziger 1986b:1–26; Nordquist 1987:66–71; see also Fransman 1986:11–14, who indicates major modes of transferring knowledge through the market). Sanjaya Lall’s (1985:76) conclusion is sensible: The correct strategy then must be a judicious and careful blend of permitting TNC [MNC] entry, licensing and stimulation of local technological effort. The stress must always be – as it was in Japan – to keep up with the best practice technology and to achieving production efﬁciency which enables local producers (regardless of their origin) to compete in world markets. This objective will necessitate TNC presence in some cases, but not in others. LOANS AT BANKERS’ STANDARDS In the 1960s, the LDC balance on goods and services deﬁcit was ﬁnanced primar- ily by ﬂows from ofﬁcial or semiofﬁcial sources in the form of grants, concessional loans, and market loans. Private ﬁnance during the 1960s consisted mainly of sup- pliers’ credits and direct foreign investment. Commercial bank lending increased in the decade after 1967. As pointed out earlier, private loans fell during most of the 1980s, increased during the early 1990s, but fell again during the late 1990s through 2003. Nonconcessional loans from abroad ﬁnance a deﬁcit in the balance on goods and services account. For LDCs, the ratio of ofﬁcial aid to commercial loans declined for a decade and a half after 1970: from 1.40 in 1970 to 0.66 in 1973 to 0.55 in 1975 to 0.36 in 1978 to 0.23 in 1984. Subsequently, the ratio of ofﬁcial aid to commercial loans rose from 0.23 in 1984 to 0.33 in 1987 to 0.47 in 1990 and 0.43 in 1994 to 0.95 in 2002. The increasing trend after the mid-1980s mostly reﬂected the fall in private lending rather than substantial growth in concessional assistance. By the late 1980s and early 1990s, low-income countries, with more than twice the population of middle-income countries, received twice the ofﬁcial assistance that middle-income countries did, in contrast to the 1970s, late 1990s, and early years of the 21st century, P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 541 when aid was relatively evenly divided among the country categories. However, all but a small fraction of commercial loans were to middle-income countries with high credit ratings (World Bank 1980i; OECD 1981; OECD 1982; World Bank 1981i:49– 63; Overseas Development Council 1982a:215–37; Overseas Development Council 1982b:225–46; IMF 1988d:96–109; IMF 1995d:161–67; OECD 2002b). Two sources of lending fell in the late 1990s and early years of the 21st century: (1) private lending as commercial bankers became unwilling to ﬁnance in the face of debt rescheduling and default (see Chapter 16), recent nonperforming loans, and more selective lending by individual banks, and (2) ofﬁcial (or ofﬁcially supported) export credit ﬁnance (a part of short-term borrowing), and interest rates for bank ﬁnance fell. However, one source of local LDC funding is expanding – local lending by multi- national banks with headquarters in DCs. Afﬁliate banks of the major DCs in the Group of 10 15 are increasingly lending in local currency, a trend that could reduce LDC debt in foreign currency. The local currency claims of G-10 bank afﬁliates in LDCs shot up from $30 billion in 1983 to $130 billion in 1996 to $490 billion in 2002, increasing the proportion of these afﬁliates’ claims on LDCs in local currency from 7 percent in 1983 to 20 percent in 1996 to 68 percent in 2002 (World Bank 2003e:51). This decreases currency mismatches in LDCs, a phenomenon in which banks hold assets in local currency and incur liabilities in foreign currency, making the banks vulnerable to losses from domestic currency depreciation. Bilateral ﬂows. OECD ofﬁcial development assistance is only a part of the total net ﬂow of resources to LDCs. As indicated earlier, 0.22 percent of the 2001 GNP of OECD countries was foreign aid. However, additional net ﬂows included private capital and bank loans – 0.96 percent of GNP, nonconcessional ofﬁcial ﬂows – 0.04 percent of GNP, and private voluntary agencies – 0.03 percent of GNP. Thus, the total net ﬂow was 1.25 percent of GNP (OECD 1995:C3–C4; UNCTAD 2003:4). The Eurocurrency market. Eurodollars are dollars deposited in banks outside the United States, often by U.S. banks. More generally, Eurocurrency deposits are in cur- rencies other than that of the country where the bank (called a Eurobank) is located. The Eurobank system began in the early 1950s when the Soviet Union, using the U.S. dollar for international trade and fearing the U.S. government might block its deposits in U.S. banks, transferred its dollars to English banks. These (and subsequently other European) banks could lend these dollars to MNCs, banks, governments, and other borrowers. Banks increased their proﬁts by avoiding national exchange controls, reserve requirements, and bank interest ceilings, and depositors were attracted by receiving higher interest rates. In the mid-1990s, dollars comprised two-thirds of the more than $8 trillion deposits in this unregulated ﬁnancial market, which is located in Europe (London, Zurich, Paris, Amsterdam, and Luxembourg), Hong Kong, 15 The G-10, like the Big 10 conference, consists of 11 : Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 542 Part Four. The Macroeconomics and International Economics of Development Singapore, Tokyo, Kuwait, Nassau, Panama, Grand Cayman, Bahrain, and (in 1981 after U.S. banks could accept Eurodeposits) New York City. Eurobanks have played a role in lending to LDCs, including recycling petrodollars to oil-importing LDCs in the mid-1970s. Most deposits are by private nonbanks or by central banks and other ofﬁcial monetary institutions. Although the absence of reserve requirements and control by national monetary authorities provides substantial potential for the multiple expansion of bank deposits (and world inﬂation), in practice most loan funds are deposited outside Eurobanks, thus leaking out of the system (Ethier 1988:498– 509; Fusfeld 1988:799–801; Kenen 1989:453–454, 468–470; Krugman and Obstfeld 1994:642–651; Krugman and Obstfeld 2000:650–659). Funds from multilateral agencies. In 1944, 44 nations established the World Bank , envisioned primarily as a source for loans for post–World War II reconstruction; and the IMF , an agency charged with providing short-term credit for international balance of payments deﬁcits (see Chapter 5). Neither institution was set up to solve the ﬁnancial problems of developing countries; nevertheless, today virtually all ﬁnancial disbursements from the World Bank are to LDCs, and the IMF is the lender of last resort for LDCs with international payments crises. The World Bank is a well-established borrower in international capital markets, issuing bonds denominated in U.S. dollars but guaranteeing a minimal Swiss franc value when the dollar depreciates. In the early years of the 21st century, the Bank, which is the largest source of long-term developmental ﬁnance for LDCs, provided about 10 percent of the total resource ﬂows to LDCs. It lent more than $17 bil- lion to LDC governments annually, including funds for investments such as water improvement and rural infrastructure in India, telecommunications and water sup- ply in Afghanistan, mass transit in Brazil, a college of ﬁsheries in the Philippines, irrigation and ﬂood control in Indonesia, construction of hospitals, schools, roads, and sewage pipes in Argentina, and a Chad–Cameroon oil pipeline (although in 2004 environmental groups and other nongovernmental organizations challenged support by major international banks, LDC governments, and LDC mining companies of the World Bank continuing to ﬁnance LDC oil and coal projects) (World Bank 2004d; World Bank Development News , various issues). Furthermore, the World Bank has used its technical and planning expertise to upgrade projects to meet banking stan- dards, has lent for development plans and economic reform, and has led in organizing consortium packages of lenders and grant givers. A World Bank afﬁliate, the Interna- tional Finance Corporation, has invested $4 billion annually in agencies to stimulate private enterprise, such as the Industrial Credit and Investment Corporation of India, mentioned in Chapter 14. These amounts do not include soft loans (or concessional aid) of more than $6 billion annually made by another World Bank afﬁliate, the International Development Association. The IMF provides ready credit to a LDC with balance of payments problems equal to the reserve tranche – the country’s original contribution of gold – or 25 percent of its initial contribution or quota. Beyond that, other credit lines include the ﬁrst credit tranche, with 25 percent of the quota, granted on adoption of a program to P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 543 overcome international payments difﬁculties; an extended facility, with 150 percent of the quota, based on a detailed medium-term program; a supplementary ﬁnancing facility subsidy account, 140 percent of quota (ﬁnanced by repayments from trust fund loans and voluntary contributions) to support standby arrangements for eligi- ble low-income LDCs under previous programs; a compensatory and contingency ﬁnancing facility (CFF), 75 percent of quota, to ﬁnance a temporary shortfall in export earnings or excess costs of cereal imports beyond the country’s control; buffer stock ﬁnancing, 50 percent of the quota, to stabilize export earnings; an oil facility, funds borrowed from oil-exporting countries to lend at competitive interest rates to LDCs with balance of payments deﬁcits; and a subsidy account, contributed by 25 DCs and capital surplus oil exporters that makes available interest subsidies to low- income countries (Grubel 1981:531–533). To illustrate, the ﬁnancial intermediation of the IMF enabled India to borrow $2.85 billion from Saudi Arabia in 1981 at an interest rate of 11 percent, compared to 18 percent in the commercial markets. Yet, between 1983 and 1985, most special funding beyond direct IMF credits dried up, with net lending to LDCs falling from $11.4 billion to $0.2 billion, reducing IMF leverage to persuade LDCs to undertake austerity in the face of internal political opposition. However, from 1986 to 1988, the IMF added a structural adjustment facility (SAF) , which provides concessional assistance as a portion of a package of medium-term macroeconomic and adjustment programs to low-income countries facing chronic balance of payments problems; added an enhanced structural adjust- ment facility , renamed the Poverty Reduction and Growth Facility (PRGF) , “to foster durable growth” that raises living standards for the poorest IMF members making adjustments; and restored the CFF with an average grant element of 20 percent. The ﬁrst two facilities were ﬁnanced by a rotating fund from recycling the IMF Trust Fund (from the sale of IMF gold) and by Japan and European countries with external sur- pluses, but not the United States, which had an international deﬁcit and was opposed to IMF long-term concessional aid. As an example of how this aid works, in 1988, the IMF approved $85 million ($35 million as SAF and $18 million as supplemen- tary funding) for Togo, whose export earnings from cocoa, coffee, palm products, and peanuts had declined from 1985 to 1987 (Feinberg 1986:14–18; World Bank 1988i:141; IMF Survey , various issues) and, in 1996–2003, support for the initia- tive for highly indebted poor countries (HIPCs), “countries that pursue IMF- and [World] Bank-supported adjustment and reform program, but for whom traditional debt relief mechanisms are insufﬁcient” (IMF 2004) (see Chapter 16). In 1999, in response to the Asian ﬁnancial crisis of 1997–98, the IMF established Contingent Credit Lines (CCL), a precautionary defense for members with trans- parency and sound policies who might, however, be vulnerable to contagion from capital account crises in other countries. After four years of disuse, CCL was discon- tinued in 2003. Countries were reluctant to use the CCL, for fear of being labeled as subject to possible crisis! In the IMF and World Bank, the collective vote of high-income OECD countries comprises a substantial majority of the total. The U.S. view of policy for LDCs is the most dominant among high-income OECD countries. The U.S. view (Summers P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 544 Part Four. The Macroeconomics and International Economics of Development 1998:14) corresponds closely to IMF policy, as the United States, with 17.5 percent of IMF shares, only needs a few DC allies to deny an IMF loan. Indeed, Strom Thacker’s (1999) econometrics provides “strong evidence that the political interests of the U.S. drive much of the behavior” of the IMF. Robert Barro and Jong-Wha Lee’s (2002) analysis of IMF lending, 1975 to 1999, shows that an LDC’s political proximity to the United States (that is, the percentage of times that country voted in the U.N. General Assembly along with the United States) signiﬁcantly increases the proba- bility and size of an IMF loan. 16 More explicitly, U.S. voting for IMF stabilization and structural adjustment lending for LDCs is signiﬁcantly related to the recipi- ent’s support of U.S. foreign policy stances. (A political and strategic motivation – to promote democracy and private enterprise and minimize Soviet inﬂuence in the third world – was important in congressional approval of President Harry Truman’s call in 1949 for U.S. “Point Four” economic assistance to LDCs.) Columbia’s Jeffrey Sachs opposes IMF and World Bank structural adjustment pro- grams in Africa, arguing that the Bretton Woods’ institutions cannot force good governance with their average of 117 loan conditions. These programs delegitimize African governments, increasing their vulnerability to overthrow, and do not empha- size diversifying production and promoting exports. The high-interest low-inﬂation strategies of the Fund and Bank were “suffocating economic growth” in Africa (Pan- African News Agency 1998). Chris Cramer and John Weeks (2002:43–61) evaluate how IMF and World Bank macroeconomic stabilization (monetary, ﬁscal, and exchange-rate policies) and structural adjustment (privatization, deregulation, wage and price decontrol, and trade and ﬁnancial liberalization) programs affect economic growth and income dis- tribution. These program, almost universal among LDCs after 1979, were mostly introduced in response to chronic macroeconomic imbalances and external deﬁcits, and required borrowing from the IMF and World Bank as lenders of last resort. The standard orthodox packages, with emphases on compressing money demand, rais- ing interest rates, and reducing the role of the state (Polack 1997:16–18), have cut economic growth and increased the probability of political instability. Barro and Lee (2002) ﬁnd that, other things held constant, IMF lending has no effect on economic growth during the simultaneous ﬁve-year period but has a sig- niﬁcantly negative effect on growth in the subsequent ﬁve years. The Brandt report even contends that the IMF’s insistence on drastic measures in short time periods imposes unnecessary burdens on low-income countries that not only reduce basis- needs attainment but also occasionally lead to “IMF riots” and even the down- fall of governments (Independent Commission on International Development Issues 1980:215–216). In 2004, the Independent Evaluation Ofﬁce of the IMF stated that the PRGF’s achievements had “fallen short of the ambitious expectations set out in the original policy documents, [especially] in improving conditions in the world’s poorest 16 Roubini and Setser (2004) are critical of IMF and DC rescue packages to support bailouts of countries that owe rich countries’ creditors and banks. The two authors favor smaller packages, implying only partial bailouts that “bail in” (or require losses from) U.S. and DC creditors that make risky loans to LDCs. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 545 countries, … fail[ing] to address controversial policy issues as well as [lacking] clear benchmarks against which to monitor progress.” The report called for greater ﬂex- ibility “to accommodate the diversity of country political and administrative sys- tems and constraints” and asked “countries to deﬁne – in a manner open to public scrutiny – their own benchmarks and objectives for improving policy-making processes” ( World Bank Development News , July 29, 2004). Paul Krugman (1999:115) criticizes the IMF for its priority, in Thailand, Indonesia, Korea, and other Asian countries undergoing crisis in 1997, on raising taxes and cutting spending to reduce budget deﬁcits and raising interest rates, adding per- haps tongue-in-cheek that “governments [must] show their seriousness by inﬂicting pain on themselves.” The effect was to reduce demand, worsening the recession and feeding panic. Surely the IMF must be satisﬁed that a borrower can repay a loan. And there may be few alternatives to monetary and ﬁscal restrictions or exchange-rate devaluation for eliminating a chronic balance of payments deﬁcit. Furthermore, as Chapters 16 and 19 indicate, the IMF’s PRDG may have recently put more emphasis on growth and efﬁciency and less on reducing domestic demand and attaining external balance. Moreover, although the third world’s collective vote in the IMF, based on member quotas, is 40 percent, LDCs often support DCs in laying down conditions for bor- rowing members so as not to jeopardize the IMF’s ﬁnancial base. Furthermore, as Kenneth Rogoff, IMF Chief Economist, 2001–03, argues (2004:65), just because we see doctors around plagues doesn’t mean they cause them; just because IMF lending accompanies LDC austerity doesn’t mean the IMF is the cause. Other major multilateral sources of nonconcessional lending in 2002 were the Inter-American Development Bank, the Asian Development Bank, the European Union, and other regional development banks. Perverse Capital Flows: From LDCs to DCs The Nobel laureate Robert Lucas (1990:92–96) asks: “Why doesn’t capital ﬂow from rich to poor countries?” The law of diminishing returns implies that the marginal productivity of capital is higher in a capital-scarce, labor-abundant economy such as India than in the United States, a capital abundant country. Lucas estimates that, with an Indian worker of the same quality as an American worker, India’s marginal product of capital should be 58 times as in the United States. Even when Lucas concedes that one U.S. worker, with more human capital, may be as productive as ﬁve Indian workers, India’s predicted return to capital would still be a multiple of the return of the United States. Lucas surmises that DC capital in LDCs encounters capital market imperfections and restrictions, speciﬁcally, economic institutions and policies and political risks that make it difﬁcult to enforce international borrowing agreements. Moreover, would an MNC’s technology be the same in the headquarters and LDC afﬁliate? Perhaps not, as technology usually needs to be modiﬁed when shifted to a different economy and culture. Chapter 16 discusses capital ﬂight in more detail. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 546 Part Four. The Macroeconomics and International Economics of Development Carmen Reinhart and Kenneth Rogoff (2004:53–58) have another explanation for the paradox of poor to rich capital ﬂows: the prime role of political and credit-market risk in many LDCs. They show that the number of years a country has been in default during the last 55 to 60 years is central in explaining capital ﬂows and per-capita income levels. Ironically, the true paradox, they indicate, may be that “too much capital … is channeled to ‘debt-intolerant’ serial defaulters.” Massive Capital Inﬂows to the United States The major example of counterintuitive capital inﬂows is that to the United States. Since the last quarter of 1985, the United States has been the world’s largest inter- national debtor. By the end of 2003, the U.S. gross external debt, a stock concept that represents the accumulation over time of international deﬁcits, was $6,800,485 million (U.S. Treasury 2003). Indeed, in 2000, the peak year of the business cycle, the U.S. current account deﬁcit was ﬁnanced by 8 percent of the combined savings of the rest of the world! By 2003, the deﬁcit represented 10 percent of the rest of the world’s savings (World Bank 2003e:37). How can we explain this? Because of the widespread use of the dollar for interna- tional payments and reserves, global companies and central banks have accumulated dollar assets amid the United States’ persistent balance on goods, services, and income deﬁcit. The United States was able to do this because it has been the world’s major reserve and trading currency. Unlike Argentina, Thailand, and Nigeria, the United States has borrowed its funds in its own currency, U.S. dollars, at relatively low interest rates. As pointed out in Chapter 17, the United States has had a persistent surplus (compar- ative advantage) in the trade of services and ﬁnancial assets. U.S. rapid productivity growth, at least in the 1990s, from cheaply coordinatin

bundet

g global value-added steps into ﬁnal assembly and sales, increased foreigners’ expectations of high rewards from their investments. Productivity growth made U.S. assets extremely attractive to both domestic and international investors (Mann 1999). As a balance of payments state- ment similar to Table 15-1 points out, the U.S. capital account, that is, capital inﬂows and the rest of the world’s increased holding of U.S. assets, a ﬂow concept, equals the current account, a major component of which has been the trade deﬁcit. The opportunity cost of investment forgone in the LDCs’ domestic development is substantial. Furthermore, exporters to the United States or those competing with those selling at dollar prices suffered terms of trade losses, whereas nonoil exporters priced in currencies other than dollars enjoyed terms of trade beneﬁts, including price gains when importing petroleum, priced in dollars. Economists such as Catherine Mann think the continuing deﬁcit in the United States is unsustainable, partly as interest and dividends to service the debt increases as U.S. liabilities to foreigners rise. In addition, some world’s asset holders may shift from the U.S. dollar as reserve currency and medium of exchange to other currencies, such as the euro , the common currency created by the 12 members of the P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 547 European Economic and Monetary Union (a subset of the European Union) in 1999, a move that may weaken the dollar. Foreign central banks, who ﬁnanced 38 percent of the U.S. current account deﬁcit in 2003 (Ip 2004:A2), or other foreigners could eventually stop providing credit to the United States, which would have to reduce consumption to increase investment and reduce its foreign debt. In any event, the continuing external deﬁcit makes the United States vulnerable to the conﬁdence of foreign asset holders (Alan Greenspan, Speech, November 19, 2004). Conclusion Globalization involves the expansion of economic activities across nation states, deepening economic openness, integration, and interdependence among countries. External openness generally beneﬁts most of the world but is likely to marginalize peripheral countries, especially their poorest citizens. A capital inﬂow enables a country to invest more than it saves and import more than it exports. A newly industrializing country that effectively uses an inﬂow of foreign funds should usually be able to pay back its debt from increased output and productivity. Exports minus imports of goods and services equal the international balance on goods, services, and income. Aid, remittances, loans, and investment from abroad ﬁnance a balance on goods and services deﬁcit. Countries give concessional aid to LDCs for reasons of national economic and political interest, ideology, humanitarianism, and global political maintenance. In 2001, aid from Organization for Economic Cooperation and Development (OECD) countries (the West and Japan) fell to $51.4 billion, 0.22 percent of GNP. Aid given by the United States, the largest giver, was also lowest as a percentage of GNP. The grant component of OECD concessional aid to LDCs was 94 percent. The major multilateral agencies providing concessional aid to LDCs were the Inter- national Development Association (a World Bank afﬁliate), the Commission of the European Communities, and the United Nations. A large share of international trade is multinational corporations’ intra-ﬁrm trade. Although the United States still accounts for the largest share of the world’s foreign, private investment, its share steadily declined between 1971 and 2001. The largest multinational corporations have an economic strength comparable to that of the LDCs with which they bargain. In 2001, the top 10 recipients received 73 percent of inward foreign direct investment (FDI). China was the leading LDC recipient of FDI. Although MNCs in developing countries provide scarce capital and advanced tech- nology for growth, doing so may increase LDC dependence on foreign capital and technology. The LDCs need a judicious combination of MNCs, joint MNC–local ventures, licensing, and other technological borrowing and adaptation. Loans to developing countries at bankers’ standards fell from 1990 to 2002. Why doesn’t capital ﬂow from rich to poor countries? LDC capital markets are imperfect and often subject to political risk. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 548 Part Four. The Macroeconomics and International Economics of Development Why does 10 percent of the rest of the world’s savings ﬂow to the United States? The United States has the most highly developed market for ﬁnancial assets, and attracts savings as the world’s largest reserve and trading currency. TERMS TO REVIEW r aid (ofﬁcial development assistance) r antiglobalization r average propensity to remit r bilateral aid r capital import r concessional funds r current account r direct investment r euro r eurocurrency r eurodollars r fungible r General Agreements on Tariffs and Trade r globalization r global public goods r international balance of payments statement r international balance on goods and services r International Development Associa- tion (IDA) r International Monetary Fund (IMF) r investment r multilateral aid r multinational corporations r oligopoly r Organization for Economic Coopera- tion and Development (OECD) r portfolio investment r public goods r remittances r turnkey projects r vertical integration r World Bank r hawala system QUESTIONS TO DISCUSS 1. Using national income equations, explain an inﬂow of capital from abroad in terms of expenditures–income, investment–saving, and import–export relation- ships. Indicate the relationships between expenditures and income, investment and saving, and imports and exports for a country paying back a foreign loan. Does repaying the loan have to be burdensome? 2. What is globalization? What are the similarities and differences between glob- alization, 1870–1913, and that after 1950? How much has the world’s people gained from globalization? What about LDCs? Which groups are the major win- ners and which the main losers? 3. To what extent does the Brandt Commission’s view of DC and LDC interdepen- dence conﬂict with Frank’s view of LDC dependence? 4. How can foreign aid, capital, and technology stimulate economic growth? How could the roles of foreign aid, capital, and technology vary at different stages of development? 5. What are Chenery and Strout’s two gaps? How do foreign aid and capital reduce these two gaps? What are the strengths and weaknesses of the two-gap analysis? P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 15. Balance of Payments, Aid, and Foreign Investment 549 6. What are sources for ﬁnancing an international balance on goods and services deﬁcit? Which was the most important source for LDCs in the 1990s? 7. How effective has DC aid been in promoting LDC development? How effective has food aid been? 8. What are the costs and beneﬁts for donor countries giving aid to LDCs? Do the costs outweigh the beneﬁts? Choose one donor country. What are the costs and beneﬁts for this country giving aid? Do the costs outweigh the beneﬁts? 9. What is the trend for OECD aid as a percentage of GNP in the last two decades? 10. Compare economic aid to low- and middle-income countries since the 1980s? How do you explain changes in allocation over time? 11. How important was multilateral aid as a percentage of total economic aid in the last two decades? 12. What can LDCs do to increase direct foreign investment in their countries? 13. What are the costs and beneﬁts to LDCs of MNC investment? How has the balance between costs and beneﬁts changed recently? 14. What was the trend in the ratio of ofﬁcial aid relative to commercial loans to LDCs in the last three to four decades? How important is multilateral lending as a source of nonconcessional loans? 15. How important has the World Bank been as a source of funds for LDCs? How important has the IMF been as a source of funds for LDCs? Do you think there should be any changes in World Bank and IMF programs and conditions? GUIDE TO READINGS There are a plethora of reports by international agencies related to Chapters 15– 17 on the international economics of development. Annual publications include the World Bank’s World Development Report, World Development Indicators, Global Economic Prospects , and Global Development Finance ; UNCTAD’s World Invest- ment Report, Trade and Development Report , and Least Developed Countries ; IMF’s World Economic Outlook (also balance of payments data by world region); OECD’s Development Cooperation and OECD in Washington: Recent Trends in Foreign Aid (consult source in Bibliography); and corresponding CD-ROMs. The Institute of International Economics in Washington, D.C. (http://www.iie.com) provides papers and speeches and lists many monographs on the balance of payments, aid, and FDI. For discussion of the meaning of globalization and some historical parallels to contemporary globalization, see Nayyar (1997). Rodrik (1998) discusses how glob- alization has increased social tensions. Other economists on globalization include Nayyar, ed., Governing Globalization (2002), Stiglitz and Muet, eds., Governance, Equity, and Global Markets (2001), Bhagwati, In Defense of Globalization (2004), Stiglitz, Globalization and Its Discontents (2002b), Chang, ed., Joseph Stiglitz and the World Bank: The Rebel Within (2001), and World Bank, Globalization, Growth, and Poverty (2002). The listserv World Bank Development News is a good source to keep up on recent developments. P1: PIG 0521829666c15 CB970/Nafziger 0 521 82966 6 October 20, 2005 13:36 550 Part Four. The Macroeconomics and International Economics of Development Easterly (2001a) critiques World Bank and U.S. aid. World Bank (2000a:Chapter 8) discusses African aid dependence, poverty-reducing aid, aid delivery, and aid out- comes, and World Bank (2002a) makes the case for Bank aid. IFPRI’s Web site, http://www.ifpri.org, has information on sources on food aid. The U.S. Agency for International Development Web site is http://www.usaid.gov/. Abhijit Banerjee, Esher Duﬂo, Sendhil Mullainathan, Marianne Bertrand, and Har- vard’s Michael Kremer, at MIT’s Poverty Action Lab, use randomized experiments to test the effectiveness of aid projects. Duﬂo found that providing poor Kenyan stu- dents with free uniforms or a porridge breakfast increased school attendance but that drugs to treat intestinal worms, a cost of $3.50 for a year’s schooling, was even more cost-effective. Mullainathan, in a project to test job discrimination in Boston and Chicago, found that applicants with white-sounding names (such as Emily Walsh or Brendan Baker) were more likely to receive requests for interviews than those with black-sounding names (such as Lakisha Washington or Jamal Jones) (Dugger 2004; Poverty Action Lab 2004). P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16 The External Debt and Financial Crises Scope of the Chapter Chapter 15 mentioned that the LDCs’ persistent deﬁcit on the balance on goods, services, and income through the 1980s and 1990s, together with a decline in loans at bankers’ standards in the mid- to late 1990s, contributed to a continuing LDC debt crisis. The debt crisis for Latin America and other middle-income borrowers, primarily owed to commercial lenders, was of a different nature than that of sub- Saharan Africa, who owed its debts primarily to bilateral government and multilateral lenders. Jubilee 2000, launched by nongovernmental organizations, put pressure on the World Bank, IMF, and DC donors to relieve, write down, or forgive the debts of the highly indebted poor countries (HIPCs), largely from Africa. The most fundamental change in the international economic system in the 1990s was the incredible rise in international capital mobility, with about $2 trillion crossing borders daily (You 2002:216), from which middle-income countries received massive capital inﬂows. Global foreign exchange transactions rose from a mere $15 billion per day in 1973 to $60 billion in 1983, exploding to $900 billion in 1992, and contin- uing to increase in the years after that. Thus, the worldwide ratio of foreign exchange transactions to world trade was 9:1 in 1973, 12:1 in 1983, and 90:1 in 1992. World GDP in 1992 was $64 billion daily compared to $10 billion exports and $900 billion foreign exchange transactions, in excess of the foreign exchange reserves of the world’s central banks, $693 billion, inadequate to cope with sudden shifts in the direction of global currency ﬂows (Nayyar 1997:3–4). Not surprisingly, ﬁnancial crises occurred in Mexico (1994), Southeast and East Asia (1997–99), and Argentina (2001–03) following capital-account liberalization and substantial increases in capital inﬂows. On the one hand, Ranciere, Tornell, and Westerman (2003) show that among 52 LDCs, ﬁnancial liberalizers grew by 2 percentage points faster than nonliberalizers, with bank credit growth responsible for about half the advantage. Yet, on the other hand, East and Southeast Asian countries experiencing ﬁnancial and currency crises suffered an output reduction from 1997 to 2001 worse than the Great Depression. Still, despite Thailand’s depression during the 1997–99 ﬁnancial crisis, its growth in GDP per capita was 4.5 percent yearly, 1980–2001, compared to India’s 3.3 percent annual growth for the same period (Economist 2003h:77), a cumulative growth difference of more than 50 percent. 551 P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 552 Part Four. The Macroeconomics and International Economics of Development TABLE 16-1. Total External Debt of LDCs (selected years, 1970–2001, in $ billions) 1970 49 1976 157 1982 816 1984 908 1986 1216 1989 1411 1992 1662 1995 2066 1998 2395 1999 2427 2000 2364 2001 2322 Sources: Organization for Economic Coop- eration and Development 1988:218; World Bank 1978i:96–97; World Bank 1988i:258–259; World Bank 1993i:170–171; World Bank 2003e. This chapter examines both debt and ﬁnancial crises, despite their differences in origin. We also discuss the deﬁnition of external debt, the origins of the debt crisis, how capital ﬂight exacerbates the debt problem, the U.S. bankers’ and LDC gov- ernments’ perspective on the crisis, indicators of debt, net transfers, the major LDC debtors, the roles of World Bank and IMF lending and policies, proposals to resolve the debt crisis, and the distributional effects of the debt crisis and relief measures. Deﬁnitions of External Debt and Debt Service A country’s total external debt (EDT) includes the stock of debt owed to nonresident governments, businesses, and institutions and repayable in foreign currency, goods, or services. EDT includes both short-term debt, with a maturity of one year or less; long-term debt, with a maturity of more than one year; and the use of IMF credit, which denotes repurchase obligations to the IMF. External debt includes public and publicly guaranteed debt, as well as private debt (World Bank 1993i:ix, 158–159). Debt service is the interest and principal payments due in a given year on long-term debt. Origins of Debt Crises Except for modest reductions in the early 1990s and early years of the 21st century, nominal LDC external debt increased from 1970 to 1999 (Table 16-1) for several reasons: 1. External debt accumulates with international balance on goods, services, and income deﬁcits. LDC international deﬁcits increased from a series of global P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 553 shocks, including the 1973 to 1974 and 1979 to 1980 oil price rises (which reduced non-oil-producing LDCs’ terms of trade) and the recession of the indus- trialized countries, 1980–83, and continuing slow growth during the remainder of the 1980s (with sharply falling commodity prices, slowed export expansion, and increased OECD protectionism). Deﬁcits increased throughout the 1990s until mid-1998 through 2003, as borrowers paid down debts (Chapter 15). 2. As indicated in Chapter 15, DCs relied more on private bank and other com- mercial lending, increasing its ratio to ofﬁcial aid from 1970 to the mid-1980s. Ofﬁcial development assistance (ODA) declined sharply in 1982–83 during the DCs’ recession, when LDC external debt grew at a faster rate from rising inter- est rates. After the mid-1980s, the trend for both commercial ﬂows and ofﬁcial aid was downward or constant, at best, in real terms (Overseas Development Council 1982b:225–468; IMF 1988:96–109; and Chapter 15). 3. Like Iowa farmers and Pennsylvania small business people, LDCs reacted to the input price hikes of 1973 to 1975 by increasing their borrowing. The quadrupling of world oil prices in 1973 to 1974 poured tens of billions of petrodollars into the global banking system, which were “recycled” as loans to LDCs and U.S. farmers and business people at low rates of interest. They were lured by negative world real interest rates , the nominal rates of interest minus the inﬂation rate, − 7 percent in 1973, − 16 percent in 1974, and − 5 percent in 1975. Many of these debts came due in the early 1980s when high nominal rates of interest, together with low inﬂation rates, resulted in high real interest rates (9–12 percent in 1982 to 1985) (Krueger 1987:169; Rahimibrougerdi 1988:6, 83; Cavanagh, Cheru, Collins, Duncan, and Dominic Ntube 1985:25). For many LDCs, the debt burden became a treadmill, with debt rollovers or rescheduling or, worse yet, defaults with higher interest rates or lack of access to credit. The average interest rate for ﬁxed-interest loans (generally subsidized or long term) rose from 4 percent (1970) to 6 percent (1981) to 7 percent (1986). From 1971 to 1981, interest rates on ﬂoating-interest loans (primarily from commercial sources) increased from 8 percent to 18 percent. The decrease in the average loan maturity from 20 years in 1970 to 16 years in 1986, as well as a reduction in the average grace period over the same period from 6 years to 5 years, aggravated the problem of debt service (World Bank 1988i:260–261), reducing the probability of eliminating the cycle of debt and contraction. 4. The inefﬁciency and poor national economic management indicated before in Nigeria, Zaire, and Ghana, as well as in Latin American military governments, in the 1970s, meant no increased capacity to facilitate the export surplus to service the foreign debt. Argentina’s substantial increase in public spending in the 1970s, ﬁnanced by borrowing from abroad, increased external debt and reduced export capacity. Chapter 19 indicates that the efﬁciency of public enterprise is potentially com- parable to that of private enterprise, given a certain size ﬁrm, but that public ﬁrms are more likely to choose an excessive scale of operations, have easier access to state ﬁnancing to mute bankruptcy, and more pressure to provide jobs and P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 554 Part Four. The Macroeconomics and International Economics of Development contracts to clients and relatives than private enterprises. Few LDCs achieve the high quality of economic management by the civil service and economic policy making insulated from political pressures achieved by Taiwan and South Korea (Chapter 3). In the early 1980s, before World Bank– and IMF-imposed reforms, government employment was high in LDCs, as Chapter 19 indicates. To illustrate, in Nigeria, government expenditures as a percentage of GDP rose from 9 percent in 1962 to 44 percent in 1979 but fell to 17 percent from World Bank structural adjustment programs, such as the one in effect from 1986 to 1990, which emphasized privatization, market prices, and reduced government expenditures. Nigeria had centralized power during its 1967–70 civil war with the breakup of regions, and in the 1970s, as the oil boom enhanced the center’s ﬁscal strength. Expansion of the government’s share of the economy did little to increase political and administrative capacity, but it did increase incomes and jobs that political elites could distribute to their clients (Central Bank of Nigeria 1960– 80; Nigeria, Ofﬁce of Statistics 1960–80; Ogbuagu 1983:241–266; Nafziger 1993:50). In the 1990s and early 20th century, smaller government and Bank– Fund programs only shifted the Nigerian elite’s opportunity for rent seeking; use of state power to divert oil and treasury funds to private use remained rampant. 5. The adjustment essential to export more than was imported and produce more than was spent required translating government spending cuts into foreign exchange earnings and competitive gains, usually necessitating reduced demand and wages, real currency depreciation, and increased unemployment. But when many other LDCs go through the same adjustment process, the beneﬁt to any given LDC was less. In 1985, for example, the pressure on debtor countries to increase export revenues contributed to a glut in primary products and a collapse of their prices. In the 1990s, with increased participation by middle-income coun- tries in DC-organized industrial value-added ladders, LDC competition entered another arena. Mexico reduced real wages 40 percent, increased the unemployment rate, and depreciated the peso from 1980 to 1987 to increase its external competitive- ness by 40 percent. Currency depreciation also raised the nominal interest rate essential to spur Mexicans to hold pesos rather than U.S. dollars. Few countries were willing to contract domestic employment and real wages to return the bal- ance on goods and services account to equilibrium (World Bank 1985i:62–63; Dornbusch 1986:71–75; Sachs 1988:20). 6. The lack of coordination by leading DCs in exchange-rate and ﬁnancial policies under the world’s post-1973 managed ﬂoating exchange-rate system (an interna- tional currency system where central banks intervene in the market to inﬂuence the price of foreign exchange) resulted in gyrating exchange rates and interest rates. Efforts to set target zones within which key DC exchange rates will ﬂoat have only increased destabilizing capital movements and unstable exchange-rate changes when inevitably rates approach zone boundaries. This global instability increased external shocks and undermined long-run LDC planning (Khatkhate 1987:vii–xvi). P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 555 By contrast, recent empirical evidence indicates that smoothing DC exchange- rate ﬂuctuations increases DC macroeconomic and external instability, whereas optimal ﬂuctuations are fairly substantial, creating an environment that destabi- lizes the value of currencies that LDCs hold as international reserves. With regard to DCs’ currencies, LDCs are damned if they’re stable and damned if they’re not. Developing countries incur costs from the fact that they rarely can undertake international transactions in their own currency. 7. When debts are denominated in U.S. dollars, their appreciation (increased value relative to other major currencies) during the early 1980s and much of the 1990s increased the local and nondollar currency cost of servicing such debts. Or, as in the late 1980s and early years of the 21st century, nondollar debts increased when measured in dollars that depreciate (reduce their value relative to other major currencies). For example, the dollar value of Indonesia’s 1985 debt to the Japanese, Y – – 1250 billion, increased from $5 billion to $10 billion in 1988, as the dollar depreciated from Y – – 250 = $1 to Y – – 125 = $1. Volatility in leading reserve currencies, the U.S. dollar, euro, and Japanese yen, increases instability and costs in LDCs. 8. International lenders required LDC governments to guarantee private debt. When private borrowers defaulted, the state’s external debt service increased. 9. Overvalued domestic currencies and restrictions on international trade and pay- ments dampened exports, induced imports, and encouraged capital ﬂight from LDCs, exacerbating the current account deﬁcit and external debt problems. One indicator of overvaluation, the black market exchange rate vis- ` a-vis the ofﬁcial nominal exchange rate, appreciated in sub-Saharan Africa from 1.36 in 1971 to 1.53 in 1980 to 2.10 in 1983, before falling (often at World Bank/IMF insis- tence) to 1.38 in 1985, but increasing to 1.97 in 1990 before again declining to 1.41 in 1994 and 1.27 in 1999 (Aluko 2001:3). These exchange-rate distor- tions reduced export competitiveness while spurring applications for artiﬁcially cheap foreign capital and inputs (World Bank and UNDP 1989:12–17; Aluko 2001:3). 10. Substantial capital ﬂight from foreign aid, loans, and investment and capital outﬂows of portfolio investors. Capital Flight Some bankers and economists feel it is futile to lend more funds to LDCs if a large portion ﬂows back through capital ﬂight. John T. Cuddington (1986) estimates that Mexico’s propensity to ﬂee attributable to additional external borrowing, 1974 to 1984, was 0.31, meaning that 31 cents from a dollar lent by foreign creditors left the country through capital ﬂight! The Organization for Economic Cooperation and Development suggests that the $70 billion capital ﬂight from Latin America, 1982, was double the interest portion of the Latin debt-service payments for that year. Cap- ital ﬂight intensiﬁes foreign exchange shortages and damages the collective interest of the wealthy classes that buy foreign assets. Reversing capital ﬂight will not eliminate P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 556 Part Four. The Macroeconomics and International Economics of Development the debt crisis but can reduce debt burdens and commercial bankers’ justiﬁcation for resisting increased exposure to debtor countries (Lessard and Williamson 1987; Williamson and Lessard 1987; Bank for International Settlements 1989:135–136; Naylor 1989:330–331). DEFINITIONS The many methods of exporting capital illegally include taking currency overseas, sometimes in a suitcase, directly investing black-market money, and false invoicing in trade documents. Which of the domestic holdings of foreign assets (property, equity investment, bonds, deposits, and money) should be classiﬁed as domestic capital ﬂight rather than normal capital outﬂows? Deﬁning capital ﬂight as resident capital outﬂow makes it easier to conceptualize and measure than alternative deﬁnitions that characterize it as illegal, abnormal, or undesirable to government or due to overinvoicing imports or underinvoicing exports. 1 Using the World Bank’s estimates of capital ﬂight as equal to current account balance, net foreign direct investment, and changes in reserves and debt, the largest capital ﬂights, 1976 to 1984, were from Argentina, Venezuela, Mexico, Indonesia, Syria, Egypt, and Nigeria, whereas net ﬂights from Brazil (whose real devaluation in 1980 was substantial), South Korea (whose exchange rate remained close to a market-clearing rate), Colombia, and the Philippines were negative (Cumby and Levich 1987:27–67). Whenever international capital markets are highly integrated and transaction costs are low, private individuals will have strong incentives to circumvent what appears to be arbitrary barriers to capital movements, as even the United States found in the 1960s when interest equalization taxes and foreign credit restraint programs resulted in Eurocurrency and Eurobond market expansion to satisfy the offshore demand for funds (Lessard and Williamson 1987). CAUSES Resident capital outﬂows result from differences in perceived risk-adjusted returns in source and haven countries. We can attribute these differences to slow growth, overvalued domestic currencies, high inﬂation rates, conﬁscatory taxation, discrimi- natory interest ceilings or taxes on residents, ﬁnancial repression, default on govern- ment obligations, expected currency depreciation, limitations on convertibility, poor investment climate, or political instability in source countries, all exacerbated by the United States’ abandoning income taxation on nonresident bank-deposit interest and much other investment income and (in the early 1980s) paying high interest rates. In 1982, Mexico’s devaluation and inﬂation “almost totally wiped out the value of obligations denominated in Mexican pesos.” The domestic entrepreneurial energies lost from these policies were substantial (Williamson and Lessard 1987:21). 1 For European Bank for Reconstruction and Development economists Willem Buiter and Ivan Szegvari (2002), capital ﬂight is a fuzzy concept that needs to be addressed from an economic policy, not criminal justice, perspective. P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 557 A ZAIRIAN PATHOLOGY Zaire, now Congo–Kinshasa, whose capital ﬂight cannot be tracked statistically, is a blatant example of ﬂight from LDCs desperately needing foreign exchange to resolve debt problems. Thus, foreign exchange from smuggling Zairian goods, such as diamonds, abroad is so widespread that a neighbor, Congo–Brazzaville, became a diamond exporter of some importance in the 1970s and early 1980s without having any diamond deposits! For two decades, Zaire stumbled from one debt crisis to another, lacking the capacity to pay debt service, which was $375–$625 million annually in the 1980s (Nafziger 1993:92–93; World Bank 1993g:Vol. 2, 500). For Pierre Dikoba, Zairian President Mobutu Sese Seko’s “loot[ing] the country” explained the torn tin roof, malarial mosquitoes, and the lack of furniture, books, and pictures in the Kinshasa primary school where he taught in 1991 (Davison 1991:A11). In 1988, U.S. House Foreign Affairs Chair Howard Wolpe asserted: “Literally hun- dreds and hundreds of millions of dollars have vanished into the hands or bank accounts of the president and his collaborators” (Pound 1990:A4). Peter Korner and colleagues (1986:137) estimated Mobutu’s 1984 overseas wealth at $4 to $6 billion, invested in Swiss bank accounts and Western real estates, enough to solve Zaire’s debt crisis. Indeed, if Mobutu and his allies had not taken out of the country a large proportion of funds the Zairian government borrowed abroad, Zaire might not have had a debt crisis (Erbe 1985:268–275). In 1977, President Mobutu denounced the Zairian disease, stating that “everything is for sale, everything is bought in our country. And in this trafﬁc, holding any slice of public power constitutes a veritable exchange instrument, convertible into illicit acquisition of other goods” (Lemarchand 1979:237–260). Was Mobutu unique? Chapter 4 discussed predatory rulers and failed states, in which rulers and warlords proﬁt more from political disorder than from order. This syndrome did not die with Mobutu in 1997. HOW TO REDUCE FLIGHT Source countries need robust growth, market-clearing exchange rates and other prices, an outward trade orientation, dependable positive real interest rates, ﬁscal reform (including lower taxes on capital gains), taxes on foreign assets as high as domestic assets, more efﬁcient state enterprises, other market liberalization, supply- oriented adjustment measures, a resolution of the debt problem, and incorruptible government ofﬁcials (Williamson and Lessard 1987:28–56). Haven countries can lower interest rates and cease tax discrimination favoring nonresident investment income, whereas their banks can refuse to accept funds from major LDC debtor countries. Just listing policies for source and haven countries suggests the difﬁculty of the problem. For Rimmer de Vries (1987:188), capital ﬂight is the caboose, not the locomotive, meaning that capital ﬂight is symptomatic of the ﬁnancial repression and economic underdevelopment at the root of the debt crisis, not the cause of it. We have another vicious circle – low growth, capital ﬂight, and foreign exchange restrictions that hamper growth. Ironically, John Williamson and Donald R. Lessard (1987:57), P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 558 Part Four. The Macroeconomics and International Economics of Development despite recommendation of ﬁnancial and exchange-rate liberalization, indicate that sometimes LDCs may have to use exchange controls , which limit domestic resi- dents’ purchase of foreign currency, to limit the exodus of new savings. The Africa Research Bulletin ( Economic Series , October 15, 1991, p. 10550) urges the United States to remove tax policies favoring nonresident bank deposits and Switzerland to lift secrecy protection for bank deposits (dubbed Africa’s second AIDS epidemic, “acquired Investments Deposited in Switzerland”) of African politicians and eco- nomic malfeasors facing judicial due process for criminal activity. The Crisis from the U.S. Banking Perspective U.S. regulations restricting interstate commercial bank activity and the rates that banks could pay for deposits enhanced incentives for American and European banks in the 1960s and 1970s to expand into the market for dollar deposits (or eurodol- lars, as discussed in Chapter 15) located in cities of Europe, East Asia, the Middle East, Nassau, Panama, Bahrain (and later New York City) that comprise a regu- latory no-man’s-land. The successive waves of new U.S., European, and Japanese banks entering the eurocurrency market, with no reserve requirements, fueled credit expansion, especially in the 1970s. European, Japanese, and American regional banks challenging leading American bank domination sought new markets in the 1970s. After 1974, as capital-surplus oil-exporting countries recycled petrodollars to expand credit supply while Western demand for credit contracted, bankers viewed LDCs as a new frontier for lending. LDC borrowers were attractive, as they paid a premium over DC borrowers and were thought to pose little risk because borrower or guarantor governments, deemed incapable of bankruptcy, would service their debt. Ruling elites in Latin America and sub-Saharan Africa were lured by the use of easy bank credit to enhance coalition building while postponing large debt servicing for (perhaps) a future regime (Nafziger 1993:75). During the 1980s, the inability of LDCs to pay its debt was a major international economic concern of American journalists and scholars. A complete writeoff of third world debts in the early 1980s would have wiped out many major U.S. commercial banks, which had more exposure to LDC debt than banks in any other country. Yet, in the early 1990s, the Harvard economist Benjamin Cohen (1991:47–51) asked: What- ever happened to the third world debt crisis? A partial answer is that, for LDCs, little has changed. In Africa, despite the HIPC (highly indebted poor countries) initiative, and in a few countries in Latin America, the debt overhang still keeps standards of liv- ing down and limits the investment needed to end stagnation. Meanwhile, however, LDC debt repudiation no longer threatens money-center banks of New York City, such as Citibank, Manufacturers Hanover, and JP Morgan Chase. These banks have reduced their exposure to third world borrowers, so their defaults endanger neither bank credit ratings and stock prices nor the stability of the U.S. banking system. The policy of the United States in the 1980s focused on saving its banks and averting a debtors’ cartel. By 1987, the major creditor banks no longer had to continue lending to LDCs or participate in debt rescheduling to forestall their own collapse. Thus, P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 559 although the U.S. government and commercial banks have abandoned their preoccu- pation with the debt crisis, LDC debt generally does not fall, whereas the crisis has improved only a little in Africa and parts of Latin America. During the 1980s, when commercial banks held 72 percent of Latin American debt, U.S. banks (holding 36 percent) and British banks, but few continental European banks, were vulnerable to Latin default. LDC debts to U.S. banks as a percentage of their capital grew from 110 percent in 1978 to 154 percent in 1982, before falling to 114 percent in 1986 and 63 percent in 1988. For the nine major U.S. banks, this percentage was even higher: 163 percent in 1978, 227 percent in 1982, 154 percent in 1986, and 198 percent in 1988. Assume a bank’s LDC debt–capital ratio is 100 percent, and the bank writes off 60 percent of LDC debt but none of the other debts. If the loan–capital ratio is 1200 percent (this ratio typically varies between 1,000 and 1,700 percent for U.S. banks), then bad loans as a percentage of capital are at the precarious level of 5 (60/1,200) percent. In response to nonperforming LDC loans and petrodollar shrinkage from low world oil prices, U.S. banks reduced their loans to oil-importing LDCs from $121 billion in 1982 to $118 billion in 1984 to $100 billion in 1986. Indeed, the United States, which ranked ﬁrst in the world in commercial bank lending to LDCs from 1970 to 1983, fell to second place from 1984 to 1989, with only about half the loans of Japan. However, from 1989 to 1993, loans to LDCs no longer fell with their major loan restructuring. Also, U.S. bank exposure to LDC foreign debt declined in the mid-1980s from loan writeoffs, write-downs, and asset sales. 2 In 1988, Latin American, Philippine, and Polish loans held by U.S. banks sold at a 40–70 percent discount on the second-hand market, indicating market expectation of partial default. Secondary market prices of bank debts of severely indebted coun- tries (based on present value of debt service/annual GNP in excess of 80 percent or present value of debt service/annual export ratio more than 200 percent) (World Bank 1993g:Vol. 1, 165) ranged from 4 percent for Peru and 6 percent for Cote d’Ivoire to 24 percent for Nigeria to 64 percent for Chile. Steadily increasing discounts for LDC bank debt, the reduction of commercial lending to LDCs, and the increasing interest and principal arrears throughout the late 1980s indicate how much debtor countries’ creditworthiness had deteriorated. Spreads and Risk Premiums Commercial banks charge a risk premium for LDC borrowers, a premium that rises with major ﬁnancial crises. This premium or spread may vary from interest rates 1–2 percentage points in excess of the London Interbank Offered Rate (LIBOR),a virtually riskless interest rate used as a standard for comparing other interest rates, 2 Dornbusch (1986:63–86); “Debt Breakthrough,” Wall Street Journal (December 30, 1987): pp. 1, 4; Sewell, Tucker, and contributors (1988:231); Buiter and Srinivasan (1987:412); IMF Survey (January 25, 1988), p. 17, and (December 12, 1988), p. 385. P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 560 Part Four. The Macroeconomics and International Economics of Development FIGURE 16-1. Secondary-Market Spreads on Emerging Markets, 1990–2002. Note: Country names mark date of ﬁnancial crisis. Source: World Bank 2003h:45. to 15 percentage points (equal to 1500 basis points in Figure 16-1), 14 percentage points at the time of the Russian ﬁnancial crisis, and lesser points for crises in Turkey, Argentina, and Brazil (Ghai 1991:2). 3 U.S. banks learned their lesson in the 1980s, not repeating their exposure to LDC debt again. The Crisis from the LDC Perspective But although DC banks reduced their vulnerability to LDC bad debts in the late 1980s, 1990s, and early years of the 21st century, external LDC debt increased from more than $1 trillion in the late 1980s to $2.3 trillion in 2001. GNP per capita declined in Latin America and Africa during the 1980s, designated a “lost development decade.” Severely indebted countries (SICs) of the 1980s grew slower than countries of any debt classiﬁcation, and more than one annual percentage point slower than LDCs generally. Indeed, from 1980 to 1985, a period of high interest rates and rapid accumulation of debt stock, annual real GNP per capita of lower income SICs, primarily from sub-Saharan Africa, fell sharply, by 4.6 percent. Even middle- income SICs’ real per capita GNP fell by 2.2 percent during the same period (World Bank 1993g:Vol. 1, 170–233; World Bank 1994i:162–213; United States Council for Economic Advisers 1990:236). In the 1990s, with increased debt negotiations, growth in severely indebted LDCs was not hampered so much. In sub-Saharan Africa, the debt overhang contributed to the fall in health spending, child nutrition, and infant survival among the poor in the early 1980s, and the decline in real wages, employment rate, and health and educational expenditure shares in the late 1980s. In 1989, the Economic Commission for Africa’s Executive Secretary Adebayo Adedeji observed that Africa would not recover without lifting the “unbearable albatross” of debilitating debt burdens, low export prices, and net 3 One hundred basis points are equal to a 1-percentage point increase in interest rates. However, as Demirguc-Kunt and Detragiache (1994:261–285) point out, commercial lenders charged South Korea (in 1990, still classiﬁed as an LDC, with the ninth largest LDC debt), Indonesia, and Turkey lower interest rates than the market rate. Indeed, during the 1980s, these countries sometimes even paid interest rates below LIBOR. The three countries beneﬁted from considerable ofﬁcial borrowing, with substantial concessional components, from DC donors. P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 561 capital outﬂow (including capital transfer to the West by the wealthy and politically inﬂuential) (UNICEF 1989; Harsch 1989:47). About the same time, several African countries imposed debt service ceilings or debt moratoria, or simply defaulted on debt. Debt crises have forced many countries to curtail poverty programs, even though few of these programs have been funded by foreign borrowing. In 1985, Tanzanian President Julius K. Nyerere asked, “Must we starve our children to pay our debt?” UNICEF (1989) found that child malnutrition increased and primary school enroll- ment rates declined in the 1980s in many least-developed countries as external debt constraints cut spending on services most needed by the poor. Additionally, some Latin America countries, dominant among severely indebted middle-income countries, experienced deterioration in social indicators during the 1980s. In mid-1985, Peru’s President Alan Garcia limited debt payment to 10 per- cent of exports. Brazil’s President Sarney put a moratorium on interest payments for 12 months in February 1987, explaining his country’s impatience by indicating that “a debt paid with poverty is an account paid with democracy” (Ranis 1987:189–199; O’Donnell 1987:1157–1166). Creditors cut Brazil’s short-term credits, although the U.S. Federal Reserve and Treasury arranged a short-term debt settlement a year later (1988). At a meeting of leaders of debtor nations in late 1987, Argentine President Raul Alfonsin indicated that the West must recognize how “current economic condi- tions impede our development and condemn us to backwardness. We cannot accept that the south pay for the disequilibrium of the north.” The debt and ﬁnancial crises in Mexico (1994), Brazil (1998), Russia (1998), Turkey (2000), Argentina (2001), and Thailand, Indonesia, and Korea (1997) reduced output and increased poverty. All except Brazil and Russia had reduced GDP the year after the crisis; Argentina, Indonesia, and Thailand had a fall in GDP of more than 10 percent; and Turkey, Korea, and Mexico reduced output by more than 5 percent (Figure 16-2). Indonesia’s national poverty rate rose from 16 percent in 1996 to 27 percent in 1999 (World Bank 2003h:59). In Argentina, the richest Latin American country in 2001 (inside front cover table), more than 15,000 workers, unemployed, and youth marched December 4, 2002, on the government palace in Buenos Aires in a “national march against hunger.” Studies had shown that seven of ten Argentine children “suffer from a serious lack of food” (Vann 2002). The number earning their living scavenging trash doubled in two years to about 40,000 of the 13 million people of greater Buenos Aires (Moffett 2002). Argentina’s collapse had a ripple effect on the Southern Cone Common Market (MERCOSUR) countries (Uruguay, Paraguay, and Brazil), contributing to a fall in Latin America and the Caribbean’s GDP per capita in both 2001 and 2002, the only LDC region experiencing reductions in both years. In 1989, in response to increased poverty in adjusting countries, IMF Managing Director Michel Camdessus asserted: The ﬁrst [conviction] is that adjustment does not have to lower basic human standards. … My second conviction is that the more adjustment efforts give proper weight to social realities – especially the implications for the poorest – the more P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 562 Part Four. The Macroeconomics and International Economics of Development FIGURE 16-2. The Effect of the Financial Crises on Asian, Latino, Russian, and Turkish Real GDP Growth . Source: Fischer (2003:16), citing IMF, World Economic Outlook . successful they are likely to be. … People know something about how to ensure that the very poor are spared by the adjustment effort. In ﬁnancial terms, it might not cost very much. Why? Because if you look at the share of the poorest groups in the distri- bution of these [adjusting] countries income, it is a triﬂing amount. … Unfortunately it is generally “everyone else,” and not the poverty groups, that is represented in government. (quoted in Grant 1989:18–20) Paul Mosley, Jane Harrigan, and John Toye (1991:Vol. 1, 54) observe that state- ments such as this by Camdessus “almost certainly exaggerate the extent to which the Fund at the operational level has moved or will move away from this tradi- tional brief,” that is the required internal changes for restoration of a sustainable macroeconomic recovery. Indeed, the IMF (and World Bank) stress income distri- bution and basic needs in their publications but have few systematic studies of the effects of adjustment on poverty and income inequality and few programs to ensure that adjusting countries protect the income and social services of the poor. Bank and Fund adjustment programs may need to support income transfers for the poor, as most LDCs (except for upper-middle-income countries such as Brazil and Turkey) lack the resources to support these transfers. For example, in the poorest African countries, where the majority of the population lives close to subsistence, welfare payments to bring the population above the poverty line would undermine work incentives and be prohibitively expensive. The World Bank’s Social Dimensions of Adjustment Projects (SDA), discussed in Chapter 6, is a step toward compensating the poor for losses from adjustment programs (World Bank 2003f:8). P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 563 Debt Indicators The debt-service ratio is the interest and principal payments due in a given year on long-term debt divided by that year’s exports of goods and services. This ratio for LDCs increased from 9 percent in 1970 to 13 percent in 1979 to 18 percent in 1983 to 20 percent in 1986 to 23 percent in 1988 and 21 percent in 1989, before falling to 19 percent for each of the years, 1990 to 1993, and 18 percent in 2001 and 2002. The fall in the ratio from the late 1980s to the 1990s was a result of a slight shift from debt to portfolio investment ﬁnancing, In 2001, LDC debt-service ratios were 33 percent in Latin America and the Caribbean, 18 percent in East and Central Europe and Central Asia, 12 percent in East Asia, Southeast Asia, and the Paciﬁc, 12 percent in South Asia, 12 percent in sub-Saharan Africa, and 10 percent in the Middle East and North Africa (World Bank 2002a:222–249; World Bank 2003f:95–103). The debt-service ratio for severely indebted middle-income countries was 70 per- cent, with an average ratio, 1999–2001, of 81 percent in Brazil, 67 percent in Argentina, and 50 percent in Lebanon. These percentages mean that at least half of annual export revenues must be devoted to paying interest and principle on debt, an unsustainable level. Not surprisingly, Argentina had to default and resched- ule debt in 2001–03. Debt-service ratio was 19 percent in severely indebted low- income countries, 12 percent in moderately indebted low-income countries, 16 per- cent in moderately indebted middle-income countries, and 13 percent for lesser indebted LDCs (World Bank 2002e:222–245), lower than Brazil and Argentina because of less access to credit. The severely indebted low-income countries’ and sub-Saharan ratios would have been higher except for the HIPC initiative at the millennium. Indeed, debt-service ratios in sub-Saharan Africa during the 1980s and 1990s reﬂect substantial default and debt rescheduling and forgiveness. For example, in 1990, whereas Latin America’s actual debt-service ratio, 27 percent, exceeded the sub- Sahara’s 24 percent, the sub-Sahara’s scheduled debt payments percentage, 66 per- cent, was more than twice Latin America’s 30 percent (World Bank 1993g:Vol. 1, 164–209; Nafziger 1993:16–17). Another indicator of LDC debt burden, debt as a percentage of GNI, increased from 12 percent in 1970 to 24 percent in 1980 to 33 percent in 1984 to 37–40 percent from 1986 to 2001 debt/GNI was 71 percent in sub-Saharan Africa, 49 percent in Eastern Europe and Central Asia, 43 percent in East Asia, 33 percent Middle East, 29 percent in Latin America, and 24 percent in South Asia in 2001. When classiﬁed by exter- nal indebtedness and income levels, debt/GNI was 100 percent in severely indebted low-income countries, 79 percent in moderately indebted low-income countries, 58 percent in moderately indebted middle-income countries, and 51 percent in severely indebted middle-income countries in 2000 (World Bank 2000a:222; IMF 1988d:122– 32; Sachs 1988:17–26; World Bank 1988i:258–59; World Bank 1993g:Vol. 1, 33, 79–81, 170). (Countries are classiﬁed as severely, moderately, or less indebted coun- tries on the basis of ratios of the present value of external debt to GNP and the present value of external debt to exports.) P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 564 Part Four. The Macroeconomics and International Economics of Development TABLE 16-2. Global Real GDP Growth, 1981–2003 (GDP in 1995 prices and exchange rates; average annual growth in percent) 1981–1990 1991–2000 2001–2003 a Severely indebted LDCs 1.5 3.2 1.0 Moderately indebted LDCs 2.6 0.9 2.4 Less indebted LDCs 3.4 4.7 4.9 Developing countries 2.6 3.3 3.3 Middle income 2.3 3.3 3.1 Low income 4.2 3.1 4.3 High income 3.1 2.5 3.7 a Estimated. Source: World Bank 2003h:187. Net Transfers Net transfers are net international resource ﬂows (investment, loans, and grants) minus net international interest payments and proﬁt remittances. As a result of substantial debt servicing, net transfers were negative from Latin America from 1986 to 1990 and from developing countries generally from 1986 to 1988. Because the lion’s share of the poorest LDCs has been in sub-Saharan Africa, the majority of its net resources ﬂows were concessional from 1984 through 2000, but not thereafter. This concessional aid contributed to positive net transfers in the sub- Sahara every year from 1980 to 2000. Still, the IMF received net transfers from sub-Saharan Africa, 1983 to 1993, as repayment obligations exceeded new loans, even though the Fund introduced con- cessional adjustment facilities in the late 1980s. During the same period, however, net transfers from the World Bank (including the International Development Associ- ation concessional window) to the sub-Sahara was large and positive every year, thus partially offsetting the Fund’s net transfer from the sub-Sahara. The World Bank’s aversion to negative net transfers to the most debt-distressed world region may be deliberate, even though the Bank refuses to conﬁrm the policy, perhaps for fear of establishing a precedent (World Bank 1993g:Vol. 1, 171–232; Nafziger 1993:34, 211). Major LDC Debtors Who have been the major LDC debtors? In 2001, the leaders were Brazil ($226 bil- lion), China ($170 billion), Mexico ($158 billion), Russia ($153 billion), Argentina ($137 billion), Indonesia ($136), Turkey ($136 billion), India ($97 billion), and Thailand ($67 billion). Except for China and India, who did not liberalize their capital markets, all have suffered from major ﬁnancial and currency crises during the mid- to late 1990s. The 23 countries indicated in Table 16-3 accounted for 65 percent of total LDC debt. Yet none of these countries is least developed. Indeed, P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 565 TABLE 16-3. Total External Public Debt (EDT) by Country – Less-Developed Countries, 1995–2001 ($ billions) ($10 billion or more in 2001, ranked by 2001 debt) Country 1980 1985 1990 1995 1998 2001 Brazil 71 106 116 160 241 226 China 5 17 53 118 144 170 Mexico 57 97 106 167 160 158 Russian Federation n.a. n.a. n.a. 122 178 153 Argentina 27 51 62 99 142 137 Indonesia 21 41 69 124 151 136 Turkey 19 26 49 74 97 115 India 21 41 69 94 98 97 Thailand 8 18 28 100 105 67 Poland n.a. 33 49 44 56 62 Philippines 17 27 30 38 48 52 Malaysia 7 20 16 34 42 43 Chile 12 20 19 22 30 38 Colombia 7 14 17 25 33 37 Venezuela, R.B. de 29 35 33 36 37 35 Pakistan 10 13 21 30 32 32 Hungary 10 14 21 32 28 30 Egypt, Arab Rep. of 21 42 40 33 32 29 South Africa n.a. n.a. n.a. 25 25 24 Algeria 19 18 28 33 31 23 Czech Rep. n.a. n.a. n.a. 16 24 22 Lebanon n.a. n.a. n.a. 3 7 12 Bulgaria n.a. 4 11 10 10 10 Sources: World Bank 1993g:Vol. 1, 76–78; World Bank 1993g:Vol 2; World Bank 1990g:Vol. 1; World Bank 1990g:Vol. 2; World Bank 2003e:221. middle-income countries accounted for 79 percent of the $2.2 trillion outstanding debt of LDCs in 2001. Only Indonesia and middle-income Argentina, Brazil, and Lebanon are classiﬁed as severely indebted. Severely indebted low-income countries such as the Democratic Republic of Congo, Cote d’Ivoire, Ethiopia, Nigeria, and Sierra Leone, which were not beneﬁciaries of Jubilee 2000 write-downs and conces- sional funds, have debt burdens more difﬁcult to bear than the majority of those listed in Table 16-3. Between January 1980 and December 2002, 78 LDCs (including transitional economies) renegotiated their foreign debts through multilateral agreements with ofﬁcial creditor groups (the Paris Club ) or with commercial banks (under London Club auspices), lengthening or modifying repayment terms. These countries included most sub-Saharan countries, and the countries listed in Table 16-3, except for China, India, Malaysia, Thailand, Colombia, Hungary, South Africa, and Lebanon (World Bank 1993g:Vol. 1, 94–111; World Bank 2003e:142–155). P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 566 Part Four. The Macroeconomics and International Economics of Development Yet, ironically for some countries, a high rank among LDC debtors indicated a high credit rating among commercial banks. South Korea, which received substantial overseas development assistance until it graduated to high-income status in 1994 and borrowed at submarket interest rates showed that heavy borrowing can be serviced as long as exports, GNP, and debt-servicing capacity grow rapidly (Demirguc-Kunt and Detragiache 1994:261–285). Even after Korea suffered from the contagion of the 1997 Asian crisis, the U.S. Treasury and the IMF agreed to a Christmas Day rescue, persuading creditors (commercial banks) to roll over the debt of Korea, who inter- national ﬁnancial magnates decided was too big to fail (Bluestein 2001:175–205). Indeed, Korea’s debt-service ratio was only 7 percent, compared to the following for slow growers: 38 percent for Bolivia, 22 percent for Ecuador,19 percent for Ethiopia, 14 percent for Honduras, 35 percent for Kazakhstan, 23 percent for Mauritania, 37 percent for Nicaragua, 23 percent for Peru, and 25 percent for Vietnam (World Bank 1993g:Vol. 1, 234–237; World Bank 2003e:232–234). A large debt need not be a problem so long as foreign creditors believe an economy can roll over the debt or borrow enough to cover debt service and imports. Although no leading debtors were from sub-Saharan Africa, its external debt ($209 billion, comparable to Brazil’s 2001 ﬁgure) was probably as burdensome as any other world region, at least for those countries not receiving HIPC debt reductions. From 1980 through 2002, more than three-fourths of the 45 countries in the IMF African Department negotiated debt relief agreements with creditors (World Bank 2003e:145–153). From the 1970s to late 1990s, rulers of Nigeria and Congo – Kin- shasa squandered their loan funds, sometimes expanding patronage for intermedi- aries and contractors so rapidly that they lost track of millions of dollars borrowed from abroad. During Nigeria’s second republic (civilian government), 1979 to 1983, the ports sometimes lacked the capacity for imports such as cement going to gov- ernment agencies controlled by politicians distributing beneﬁts to clients. Compared to Asian–Latin debtors, the two African countries have poorer credit ratings among commercial banks because of poor national economic management, as reﬂected in previous balance of payments crises, and a slow growth in output and exports. Financial and Currency Crises As pointed out in this chapter’s introduction, the extraordinary cross-border capital movements beneﬁted the long-term growth of recipients of inﬂows but, because of the potential reverse outﬂows, increased their vulnerability to ﬁnancial and currency crises. The Asian, Latino, and Russian crises in the 1990s and early years of the 21st century were major example of ﬁnancial and currency crises; Chapter 17 discusses the Latino and Russian crises, which introduce issues related to currency regimes and exchange rates. In Chapter 14, we indicated that ﬁnancial markets channel funds to those with productive investment opportunities poorly when banks have a high percentage of bad (nonperforming) loans, bad credit risks are disproportionately eager to take out loans, loan ofﬁcers lack information in assessing expanded lending, banks bear most P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 567 of the loss when the project of the borrowers fail, uncertainty about bank failure and government policy increases, borrowers’ collateral falls from currency devalu- ation, and interest rates increase sharply. These problems bring about asymmetries or disparities in information in which lenders have poorer information than borrow- ers about the potential returns and risk associated with investment projects. These asymmetries or disparities were present in the crises of the 1990s, when partially informed lenders steered away from making loans at higher interest rates, because they had inadequate information about borrower quality and may have feared that those willing to borrow at high interest were more likely not to pay back the loan. Screening was imperfect, especially during liberalization with new banks or with old banks formerly dependent on known state enterprises or members of the same keiretsu -like conglomerate expanding to new borrowers. Banks lack the expertise to evaluate risk, whereas weak bank supervision contributes to a failure to screen and monitor new loans enough (Mishkin 1999:11–19). Jong-Il You (2002:216) charges the IMF with contradictory signals, supporting capital account liberalization [that] expos[es] a country to the ebbs and ﬂows of capital that are regulated by the judgement and opinions of international bankers and fund managers. … Having helped generate the ﬁnancial crises by urging cap- ital account liberalization in developing and transition economies, the Fund took on the role of ﬁreﬁghters, enlisting the Bank for a supporting role. … [T]he patent failure of the Fund’s initial rescue operations in the wake of the Asian ﬁnancial crisis underscored the fact that it was ill-equipped to deal with this new form of crisis. Initial conditions in the year before the crises in Mexico in 1994 and East Asia in Thailand, Indonesia, Malaysia, the Philippines

bundet

, and Korea in 1997 indicate that capital inﬂows/GDP, bank nonperforming loan ratios, and current account deﬁcits were high; credit growth was fast; and (except for Korea) the domestic currency, set at a constant nominal rate for several years, had experienced a real appreciation 4 (that is, adjusted for inﬂation, the value of the domestic currency had increased relative to foreign currencies; Chapter 17 discusses real appreciation in more detail). Several other potential culprits – large ﬁscal deﬁcits, inﬂation, and the money supply (here currency, transactions deposits, and near money) – were not factors in the crises (Mishkin 1999:10–12). Manuel Montes and Vladimir Popov (1999:91–100) argue that successful glob- alizers take risks in internationalizing their capital markets. They suggest ﬂexible exchange rates (see Chapter 17), hedging on the forward market 5 to ﬁx rates for converting to foreign currency, and capital controls, if necessary, to prevent external pressures from increasing interest rates that contribute to domestic macroeconomic contraction. 4 Rodrik and Velasco (1999) ﬁnd that countries with short-term liabilities to foreign banks in excess of foreign reserves were three times as likely to have a sudden capital outﬂow, and thus a ﬁnancial crisis. 5 Canales-Kriljenko (2004:5) contends that LDC foreign exchange markets “are predominantly spot markets, [with] forward markets undeveloped,” thus limiting forward hedging opportunities. P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 568 Part Four. The Macroeconomics and International Economics of Development Indeed, in 1998, two prominent trade economists endorsed Malaysian capital con- trols, on the heels of recommendations that liberalizing capital accounts be a part of IMF articles and amid Malaysian Prime Minister Mahathir Mohammad’s jail- ing of Finance Minister Anwar Ibrahim on what Westerners considered trumped-up charges. The economists Paul Krugman and Jagdish Bhagwati (1998:7–12) came out in support of capital controls, followed by Mahathir’s announcement of these con- trols days later (Krugman 1999:142–146). These controls on exchange convertibility by domestic residents enabled Malaysia to attain monetary independence to expand monetary policies to increase aggregate demand, income, and employment without increasing vulnerability to capital outﬂows. Mahathir’s decision was vindicated by Malaysia’s recovery during the next year that was faster, whereas real wages and employment had smaller declines, than others hurt by the Asian crisis. Within a year, after Asia’s capital accounts were stabilizing, Mahathir restored capital convertibility (Eichengreen and Leblang 2003; Kaplan and Rodrik 2001; Komo 2001). Not sur- prisingly, however, capital controls and the ﬁring of Anwar also “provided a screen behind which [political cronies and] favored ﬁrms could be supported” (Johnson and Mitton 2001). If controls on capital outﬂows are too blunt an instrument, what about disin- centives for capital inﬂows? After massive inﬂows, Chile required foreign portfolio capital inﬂows in 1978–82 and 1991–98 (except trade credits) to deposit funds with- out interest at the central bank. The ﬁrst time Chile prohibited inﬂows with maturities below two years and set reserve requirements from 10 to 25 percent for up to ﬁve and one-half years. These controls reduced short-term inﬂows, changing the compo- sition of capital inﬂows toward longer-term capital, and allowed the central bank to raise interest rates as an anti-inﬂationary policy. To be sure, the private sector found ways to avoid controls, for example, by mislabeling portfolio inﬂows as trade credits or support for foreign direct investment (Edwards 1999:71–78). Still, taxing inﬂows may be effective for a short time and are less objectionable than restricting capital outﬂows. Moreover, as Chapter 17 argues, exchange-rate ﬂexibility combined with inﬂation targeting may be a preferable alternative. World Bank and IMF Lending and Adjustment Programs Throughout most of the post–World War II period, the World Bank emphasized development lending to LDCs, whereas the IMF lent resources to help DCs and LDCs cope with balance of payments crises. In the late 1970s, 1980s, and 1990s, LDCs with chronic external deﬁcits and debt overhang whose creditors failed to reschedule debt required economic adjustment (structural or sectoral adjustment, macroeco- nomic stabilization, or economic reform), imposed domestically or (usually) by the World Bank or IMF. In 1979, World Bank introduced structural adjustment loans (SALs) and soon thereafter sectoral adjustment loans (SECALs) . SECALs emphasized reforms in trade, agriculture, industry, public enterprise, ﬁnance, energy, education, or other sectors. SALs were no longer tied to speciﬁc projects, but to support the balance of payments through 15–20 year loans, with 3–5 years’ grace, and interest P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 569 rates only 0.5 percent above the Bank’s borrowing costs except for a front-end fee on new commitments. Structural adjustment policies emphasized growth and improved allocative efﬁciency as well as controlling domestic demand and improving the cur- rent account (Khan 1987:26–27; Nafziger 1993:xxi–xxii). In the 1980s and 1990s, the Bank led donor coordination, increasing the power of external leverage. Although IMF direct credits to LDCs fell in the mid-1980s, the IMF retained substantial inﬂuence because of IMF–World Bank cooperation and a required IMF “seal of approval” for virtually all commercial bank, bilateral, and multilateral aid and loans. In 1986–87, the IMF used trust funds and funds from sur- plus DC countries for SALs to LDCs (especially in Africa) experiencing unanticipated external shocks (Feinberg 1986:14–18). Chapter 19 analyzes World Bank and IMF adjustment policies further. Fundamentalists versus the Columbia School (Stiglitz–Sachs) 6 6 What are the origins of the Asian crisis, 1997–99? Fundamentalists, such as the Insti- tute for International Economics’ (IIE’s) Morris Goldstein (1998) see the crisis result- ing from the following: (1) ﬁnancial sector weakness, including inadequate supervi- sion (2) high bad-debt ratios, (3) large current-account deﬁcits, (4) ﬁxed exchange rates, (5) overvalued currencies, (6) contagion of ﬁnancial disturbances causing port- folio investors to reassess Asian investments, (7) increased risky behavior, including failure to hedge future transactions, by bankers and international investors, and (7) moral hazard from previous international bailouts, as in Mexico in 1994. The overextension of domestic credit by Asian banks based on excessive foreign bor- rowing at short maturities contributed to the panic of both domestic bankers and international investors. Other fundamentalists include the IIE’s Marcus Noland et al. (1998), U.S. Secretary of Treasury Lawrence Summers, 1999–2001 (Harvard’s presi- dent, 2001–), and the IMF, including Harvard’s Kenneth Rogoff, the IMF’s Director of Research, 2001–03. Joseph Stiglitz and Jeffrey Sachs agree with much of the fundamentalists’ analysis of the causes of the crisis but differ on the prescription. Fundamentalists want the IMF to lend to crisis-stricken countries on condition that they undertake fundamental structural reforms in banking. Stiglitz, however, thinks it is unrealistic for the IMF to loan short-term, expecting reforms that can only be attained in the middle- to long- run. For an LDC to establish the legal and institutional preconditions for effective banking supervision, licensing, and regulation and operational independence takes time and resources. Fundamentalists believe that the herd 7 behavior of Western portfolio investors, such as pension and mutual funds, transmitted the crisis from one Asian country 6 In 1997, Stiglitz was at the World Bank and Sachs at Harvard. Both men were at Columbia University in 2002–04. 7 The “irrational exuberance” from herding ensues from investors choosing assets others think are valuable. This is analogous, Keynes explains (1936:156), to choosing a beauty contest winner in which the prize is “awarded to the competitor whose choice most nearly corresponds to the average preferences P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 570 Part Four. The Macroeconomics and International Economics of Development to another, and then to Russia and Latin America. Stiglitz (2002a:199), by con- trast, accepts a Keynesian explanation for contagion of the crisis, viz., that the “belt tightening” imposed by the IMF reduced incomes and imports that successively weakened neighboring countries, and through the reduced demand for oil, spread to Russia. For Jong-Il You (2002:216), contagion was not a result of fundamentals but of the IMF’s failure. Having helped generate the ﬁnancial crises by urging capital account liberalization in developing and transition economies, the Fund took on the role of ﬁreﬁghters, enlisting the [World] Bank for a supporting role. The quick recoveries of Mexico and Asia … are [not] vindication [but] may simply have been a consequence of the fact that the crises were mainly panic-driven. In fact, the patent failure of the Fund’s initial rescue operations in the wake of the Asian ﬁnancial crisis underscored the fact that it was ill-equipped to deal with this new form of crisis (ibid.). Stiglitz (2002a:12–15) believes that the IMF, as initially conceived, was to under- take global collective action to ameliorate market failure. Its major task should be to support global economic stability by spurring growth and reducing unemployment. The IMF, according to Stiglitz, is a public institution provided with funds from tax- payers around the world. As such, the IMF should report to the citizens who ﬁnance it and not just ﬁnance ministries and central banks. To serve these citizens, Stiglitz opposes the conditions that the IMF sets for low-income loan recipients, the draco- nian monetary and ﬁscal policies (see Chapter 14) and adherence to free markets that were a part of the Reagan–Thatcher ideology. Stiglitz regrets changes in the Bretton Woods’ institutions, the IMF and World Bank in the early 1980s. According to him, as part of the liberal counterrevolution, the IMF shifted from a Keynesian emphasis on expanding employment and combating market failure to adopting “a new ‘Washington Consensus’” (see Chapter 5). He also regrets a purge at the World Bank at the same time that shifted its emphasis to structural adjustment loans to LDCs dependent on IMF approval and IMF-imposed conditions. Stiglitz (2002a:15) also supports the Krugman–Bhagwati view on capital controls, denouncing IMF policies of “premature capital market liberalization [which has] contributed to global instability.” Stiglitz (2002a:198) criticizes the IMF for its lack of exchange rate ﬂexibility, undertaking “massive interventions [of] billions of dollars … trying to sustain the exchange rate of Brazil and Russia.” He understands why IMF strategies are “greeted with such hostility. The billions of dollars which it provides are used to maintain exchange rates at unsustainable levels for a short period, during which the for- eigners and the rich are able to get their money out of the country at more favor- able terms. … The billions too are often used to pay back foreign creditors even when the debt was private. What had been private liabilities were in effect in many instances nationalized” (ibid., p. 209). Essentially, Stiglitz (2000a:209–211) feels that of the competitors as a whole; so that each competitor has to pick, not those faces which he himself ﬁnds prettiest, but those which he thinks likeliest to catch the fancy of other competitors.” P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 571 the IMF was more concerned about the views of the IMF, the U.S. Treasury, and the world ﬁnancial community than East Asian workers and taxpayers. We return to trade policy in Chapter 17. Changing the IMF and the International Financial Architecture How can the world ﬁnancial community contain and resolve these widespread ﬁnan- cial, capital, and macroeconomic crises in LDCs? We have discussed proposals to control damaging capital movements. This section examines ways to change the IMF and world economic governance, that is, the international ﬁnancial architecture. After that, we discuss piecemeal efforts or plans to resolve the debt crisis. Then in Chap- ter 17 we analyze how trade and exchange rate policies can diminish the frequency and intensity of these crises. Sometime World Bank economist Percy Mistry (1999:93–116) contends that the IMF exacerbated what should have been a mild currency shock into a deeper cat- aclysm by maintaining a monopoly over crisis management. Developing countries have few institutions besides the IMF to rely on during crisis; ironically, only DCs have separate international arrangements, such as the Group of Seven, European Monetary System and European Monetary Union, and Bank for International Set- tlement, for support. Asia (and perhaps other developing countries) need regional ﬁnancial institutions, such as a bank for international settlements, a regional mon- etary facility for mutual assistance and regional intervention support, a monetary fund under Asian-Paciﬁc Economic Cooperation (APEC) (a forum for spurring eco- nomic growth, cooperation, trade and investment), standby funding arrangements to support IMF programs (under APEC), regional agreements to borrow, and enhanced regional surveillance arrangements (among the central banks of ASEAN, perhaps also with Japan and China). DCs have these types of arrangements; why shouldn’t Asia? Mistry asks. For Deepak Nayyar (2002:367–368), the major missing institution is one for global macroeconomic management. In 1944, at the meeting that established the IMF, John Maynard Keynes proposed an International Clearing Union (ICU) in which all mem- bers would accept the debt obligation of the ICU’s banker. In contrast to the com- peting U.S. proposal, Keynes, the U.K.’s negotiator, wanted IMF member countries to manage demand to achieve full employment and rapid growth. To achieve this, the ICU or IMF should put the burden for correcting external imbalances on sur- plus, not deﬁcit, countries. Because of trade interactions between countries, Stiglitz (2002c:240–242), a contributor to Nayyar’s volume, sees global collective action to expand demand and employment as the preeminent global public good. “Today,” Stiglitz maintains, “Keynes must be turning over in his grave” with the major IMF thrust to cut back ﬁscal spending, increase taxes, and reduce trade deﬁcits of poor countries (ibid., p. 242). Moreover, he argues, “it is much harder for poor coun- tries to bear the risks of exchange rate and interest rate ﬂuctuations than it is for rich ones. … Debt burdens that look moderate become unbearable after big devalu- ations.” After pointing out that “This year Moldova, already desperately poor, will P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 572 Part Four. The Macroeconomics and International Economics of Development spend about 75 per cent of its government’s income on debt repayments,” he asks for international economic institutions to undertake the role of providing a mechanism for distributing risk (Stiglitz 2000a). Nayyar (2002:368) thinks that the explosive growth in international ﬁnance necessitates global macroeconomics, although he and others pressing for change despair of ﬁnding an “institutional framework for this task, which is left almost entirely to the market.” The International Financial Institution Advisory Commission (2000), appointed by the U.S. Congress and chaired by Allan H. Meltzer, recommended that (1) the IMF, World Bank, and regional development banks write off all debts of the highly indebted poor countries (HIPCs) that implement effective development policies; (2) access to IMF credit be automatic and immediate to countries meeting a priori requirements without additional conditions or negotiations; (3) the World Bank and regional devel- opment banks should concentrate on poverty reduction; and (4) because the world was on a ﬂexible exchange system, the IMF should only loan for short-term liq- uidity, until an equilibrium exchange rate is restored, and not for poverty reduction, long-term development assistance, or long-term structural reform, for which the IMF is ill-suited. In addition, the Meltzer report indicated that LDCs should not adopt pegged exchange rates. Most critics would welcome (1). However, writing off all HIPC debts requires addi- tional appropriation from the U.S. Congress for IMF, World Bank (that is, Interna- tional Development Association), and regional bank concessional aid. Other donors’ aid for debt relief waits for a U.S. initiative. On (2), as indicated in Chapter 15, no country undertook IMF prior surveillance for Contingent Credit Lines (CCL), 1999– 2003, fearing the label of being vulnerable to crisis. Many may have feared that IMF prescreening before the crisis would be more rigorous than the assessment at the time of crisis. On (3), the World Bank’s and regional banks’ moneys are revolving funds, based on recipients paying back loans. Antipoverty projects rarely pay off for multilateral banks, which need to lend at bankers’ standards to maintain funds. To enhance funds for poverty reduction requires additional concessional funds by the United States and other DCs. The George Bush administration learned this when it followed through on Meltzer Commission recommendations by calling on the World Bank in 2001 to increase its share of grants to 50 percent of social sector aid to LDCs. Other OECD countries, fearing an erosion of World Bank’s resources, opposed Bush’s effort without major concessional aid that the United States was not prepared to give. Finally, on (4): for many LDCs, attaining an exchange rate that eliminates chronic deﬁcits is much more difﬁcult than international trade theory indicates, especially with potential capital ﬂight (see earlier and Chapter 17). Given the resistance of central bankers and treasury ofﬁcials to radical change and the vested interest of the IMF in the status quo, Barry Eichengreen’s and most other economists’ proposals have been for marginal changes in the system. Eichengreen, from the University of California-Berkeley, favors Chilean-type taxes and controls on short-term capital inﬂows and encourages exchange-rate ﬂexibility (see Chapter 17). He also would require banks borrowing short-term from abroad and lending long- term domestically to hedge on the forward market, and would shift IMF conditions P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 573 for the loan from changes in monetary and ﬁscal policies to improvement in banking regulation, supervision, monitoring, and disclosure; more emphasis on securities (to be better regulated) rather than bank intermediation; protection against a small minority preventing restructuring of international bonds; “bailing in” (expanding losses to) private foreign investors and banks; corporate bankruptcy standards; and information transparency. Eichengreen’s proposal would reduce bad loans and margi- nally improve the position of LDC debtors. The next few sections discuss marginal changes recommended by the IMF economists Stanley Fischer and Anne Krueger. IMF Failed Proposals to Reduce Financial Crises Stanley Fischer, as IMF Deputy Managing Director, in discussing “On the Need for an International Lender of Last Resort” (1999:85–104), asks whether the IMF should play that lending role in ﬁnancial crises similar to those in Asia and Mexico. His standard is that of the 19th-century English economist Walter Bagehot: “In a crisis, the lender of last resort should lend freely, at a penalty rate, on the basis of collateral that is marketable in the ordinary course of business when there is no panic.” This lender’s role is to offer an assurance of credit, given under certain limited conditions, which will stop a ﬁnancial panic from spreading – or better still, stop it from even getting started” (ibid., p. 86). But this lender, to avoid market participants from taking excessive risks, should maintain constructive ambiguity (italics in the original) about when it will seek to stabilize a crisis (ibid., p. 91). Fischer thinks that the IMF should be able to reduce ﬁnancial crises, even though international capital markets cannot operate as well as U.S. domestic capital markets. According to Fischer, the IMF does at times play the role of a lender of last resort but needs to be improved to reduce the frequency and intensity of LDC ﬁnancial crises. He proposes precautionary lines of credit from private creditors to LDCs with sound policies (Fischer 1999:86–99). This proposal became the IMF’s Contingent Credit Lines (CCL), which, however, was discontinued in 2003 from LDCs’ fear of being labeled as precrisis (Chapter 15). Another suggestion by Fischer (1999:99) was to allow a stay of payments during crisis, a scaled-down version of Jeffrey Sachs’s bankruptcy proposal and a precursor of Anne Krueger’s proposal for sovereign debt restructuring in 2002, which was rejected by IMF members for the next two years. We discuss Sachs’s approach to canceling debt and the advantages of concerted action before examining Krueger’s approach. Debt Cancellation 8 8 For Sachs, sometime advisor to Latin American, Eastern European, and African economies, LDCs facing a substantial debt overhang might be better off defaulting 8 The ﬁrst three paragraphs of this section are based on Sachs (1989:279); Devlin (1989:233); Devlin (1987:91–93); Diaz-Alejandro (1984:382); Cline (1989:45); Greene (1991). P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 574 Part Four. The Macroeconomics and International Economics of Development on a portion of its debt than undertaking austere domestic adjustment or timely debt-servicing. About 20 countries undertook such unilateral action in the 1980s. Many LDC leaders felt there was no IMF adjustment program for full debt-servicing that makes the country better off than forgoing the program by partially suspending debt payments. 9 Any IMF program may be too tight relative to other options for the debtor government. The precedent for defaulting on debt is the 1930s. Countries that stopped paying their debt service recovered from the Great Depression more quickly than countries that resisted default and had virtually identical access to post–World War II capital markets. However, country default in the 1990s is more costly than it was in the 1930s, when debt was held among scattered bondholders ranging from retired individuals to large corporations, so that creditor collusion was virtually impossible. Currently, debt is, in contrast, largely held by an oligopoly of international commercial banks, which hold the lion’s share of LDC international reserves, dispense LDC credit, maintain close communication with each other, and coordinate action with the IMF and DC central banks. Moreover, contemporary LDCs face a relatively prosperous, not a depressed and divided, North. Furthermore, today’s bank cartel insists on a case-by- case approach, thus increasing their bargaining power vis- ` a-vis debtors. Yet, the debtor may be able to avoid sanctions when the lender agrees to debt reduction or cancellation or the conversion of loans to grants. Sachs (1989a:279) maintains that the best strategy for the IMF (or other international agencies) would be a program based on partial and explicit debt relief, which can serve as a carrot for political turnaround. William R. Cline (1989:45) doubts, however, that these agencies can use debt relief as a “policy bribe” in exchange for economic reform. Indeed, creditor sanctions on debtor behavior are very ineffective. The IMF’s Joshua Greene (1991) admitted that assessing African debt for rescheduling is so hopeless that it would be simpler to forgive the entire debt. Should DCs or multilateral agencies use concessional aid for debt relief or cancellation? Most large debtors are middle-income countries, and not among the poorest states. Many of the poorest countries adversely affected by external shock or growth deceleration, including Bangladesh, and most low-income sub-Saharan Africa, borrowed less by choice than necessity (low creditworthiness) (Buiter and Srinivasan 1987:414). Thus, the U.N. Conference on Trade and Development (1978) emphasized widespread debt renegotiation to cancel or reschedule debts of least- developed (largely overlapping with IDA-eligible) countries. From 1978 through 1990, 14 Organization for Economic Cooperation and Devel- opment (OECD) countries canceled more than $2 billion of concessional debt (mostly under Paris Club auspices), about one-ﬁfth of concessional loans to IDA-eligible 9 Ndikumana and Boyce (1998:2–47) argue that successor governments, such as in Congo–Kinshasa, should be able to repudiate their liabilities for prior predatory regimes’ debts (for example, the spiriting by Mobutu of ofﬁcial borrowed capital for his personal accounts overseas) on the basis of creditor complicity in odious debt. P1: POD 0521829666c16 CB970/Nafziger 0 521 82966 6 October 8, 2005 15:49 16. The External Debt and Financial Crises 575 countries in sub-Saharan Africa. Sweden, Canada, the Netherlands, Belgium, the United Kingdom, Germany, Denmark, Norway, and Finland were major contribu- tors to debt forgiveness to the sub-Sahara. OECD nations also gave recipients con- cessional aid to buy commercial bank debt instruments at heavily discounted prices (Humphreys and Underwood 1989:45; World Bank 1989g:Vol. 1, 24, 44). In addi- tion, the highly indebted poor countries’ (HIPCs) millennium initiative by the IMF, World Bank, and DC donors wrote off more than $50 billion from 2000 through February 2004 (IMF and IDA 2004:5). Concerted Action To understand IMF Deputy Managing Director Anne Krueger’s proposal for sovereign debt restructuring, we need to discuss the advantages of concerted action or collective action clauses. Debt reduction is the restructuring of debt to reduce expected present discounted value of the debtor’s contractual obligations. The general commercial debt writeoffs, write-downs, and reductions (encompassing other than the largest debtors) envi- sioned under the 1989 Brady Plan, still in effect in 2004, failed because of the lack of multilateral coordination. Bilateral arrangements are subject to free-rider problems, where nonparticipating banks beneﬁt from increased creditworthiness and value of debt holdings. Banks are willing to reduce LDC debt, but only if their competitors do likewise (Sachs 1989b:87–104). The solution lies in concerted debt reduction, in which all banks owed a debt participate jointly on a prorated basis. For debt relief, just as in U.S. bankruptcy, set- tlements (under Chapter 11 of the Bankruptcy Reform Act of 1978), concerted efforts are more effective than individual deals by creditors with debtors, and rebuilding of debtor productive capacity more effective than legalistic solutions (Sachs 1989b:239– 240; Dell 1991:139). Debt reduction can improve creditor welfare, as a large debt overhang can worsen debtor economic performance, and diminish the creditor’s expected returns. Just as in bankruptcy, decentralized market processes rarely result in efﬁcient debt reduc- tion, because each individual creditor is motivated to press for full payment on its claims, even if collective creditor interests are served by reducing the debt burden. The bankruptcy settlement cuts through the problem of inherent collective inaction and enforces a concerted settlement on creditors. Bankruptcy proceedings (under U.S. law) force individual creditors to give up some legal claims, reducing the contractual obligations of debtors, and thus preserving debtor capacity to function effectively and thereby service as much of the debt as possible. The debt overhang prevents countries from returning to the loan market; the most effective way to revive lend- ing is to reduce the debtor’s debt-servicing burden. We should apply the lesson of bankruptcy to sovereign debt overhang, even though debtor LDCs face a liquid- ity rather than a solvency problem. A major objective in debt reorganization is to reverse investment and productivity declines resulting from poor creditworthiness. Debt reduction may be the only feasible alternative, as banks, lacking incentives, are