Debt rose rapidly for some countries, particularly those in Latin America and especially for
Mexico, Brazil, and Argentina. But external debt also increased quite dramatically in the
1970s and into the early 1980s for Korea as well.6
As the table shows, the first major episode of external debt accumulation occurred during
the 1970s and the early 1980s (see Focus 16.2 for data on aggregate external debt accumu-
lation prior to the 1970s). After 1985, debt continued to rise for many countries, especially
Argentina, Brazil, India, Mexico, and Korea. In some heavily indebted Sub-Saharan African
countries, and for very special reasons discussed later, external debt showed a tendency to
fall. Korea‚Ä™s debt rose more than three times between 1993 and the 1997, as the so-called
Asian financial crisis struck hard, but the Korean economy managed to avoid the crises that
other countries have experienced (Amsden 2001: 254‚Ä“5).
Over the 1970s, private international banks provided the bulk of the loans to cover the
foreign currency shortfalls of oil importers in Latin America and Asia. For example, nearly
two-thirds of all new financing in Latin America over the period 1977‚Ä“81, and an even larger
percentage of total borrowed funds, was provided by the private banking system (Ffrench-
Davis and Griffith-Jones 1995: 240). Sub-Saharan Africa, on the other hand, borrowed
mainly from other governments or multilateral lending institutions, and their problems have
been quite different, as we shall consider below.
534 The Process of Economic Development
Table 16.1 Total external debt, 1970‚Ä“2005 (millions of US$)
1970a 1980 1985 1990 2000 2005
Argentina 1,878 27,157 44,444 62,233 146,172 114,335
Brazil 3,236 71,012 106,730 119,964 237,953 187,994
2,060 12,081 20,221 19,226 36,978 45,154
135 1,526 1,760a 4,934 4,887 5,936
C√īte d‚Ä™Ivoire 256 7,445 8,446 17,251 12,138 10,735
489 1,407 1,170a 3,734 6,657 6,739
7,940 20,582 35,460 83,628 100,367 123,123
Kenya 313 3,394 4,219 7,055 6,295 6,169
Korea 1,797 29,480 47,996 ‚Ä“ 134,417 152,800
390 6,611 13,384a 15,328 41,797 50,981
3,206 57,379 97,429 104,442 150,288 167,228
3,059 9,936 12,965 20,663 32,091 33,675
319 5,163 5,086a 14,672 15,741 18,455
Tanzania 248 2,476 9,105 6,454 7,445 7,763
Zimbabwe 233 786 2,143 3,279 4,002 4,257
Sources: World Bank 1983: 178‚Ä“9, Table 16; 1987: 232‚Ä“3, Table 16; 1995: 200‚Ä“1, Table 20; 2002: 264‚Ä“6, Table
4.16; World Development Indicators 2007, Table 4.16.
a Includes only public external debt. Other years include both public and private external debt.
Bank loans were extended at market and variable rates of interest as risk was transferred
to sovereign borrowers whose repayment obligations varied with the level of world infla-
tion.7 On the other hand, most Sub-Saharan African countries, being quite poor and higher-
risk borrowers, tended to receive the bulk of their external debt in the form of concessional
loans from non-private lenders. These loans often came with below-market interest rates
and with extended periods for repayment, often thirty years or more. Concessional loans
were provided by governments or bilateral lending institutions, such as the African Develop-
ment Bank (AfDB), or multilateral institutions, like the World Bank and the International
Monetary Fund, and not by the private international banking system (see Chapter 17 for
more details of the lending activities of the multilateral institutions).
When to borrow externally
When is it economically justified for a country to borrow externally, that is, when is it appro-
priate to incur debt denominated in foreign currencies?
External borrowing will be necessary to finance any part of a current account deficit not
covered by foreign investment inflows, aid inflows, or a reduction in a country‚Ä™s official
foreign exchange reserves.8 In fact, a country cannot incur a current account deficit without
having the ability either to borrow foreign currency or without having accumulated suffi-
cient official foreign exchange reserves to cover any spending greater than export and other
One acceptable reason to borrow externally can be to finance what is expected to be a short-
term current account deficit. This may occur as a result of some temporary imbalance in which
expenditures for imports exceed export earnings, perhaps because of an unexpected drop
in export prices caused by, say, bad weather, or any other unforeseen but transitory situation
in which import expenditures exceed export earnings and results in a current account deficit.
A temporary increase in the prices of critical imports, say oil, could be one such contingency.
The debt problem and development 535
FOCUS 16.2 THE EVOLUTION OF EXTERNAL DEbT
ACCUMULATION AND THE DEbT bURDEN
In 1970, the entire external debt of the less-developed countries totalled $68.4 billion. By
1980, external debt had multiplied by nearly ten times, reaching a total of $635.8 billion.
Debt rose less rapidly in the 1980s, but the total nearly doubled again by 1990, reaching
By 2000, estimated external debt for the low and middle-income nations totalled
$2,492.0 billion, nearly forty times larger than in 1970 and in 2005, total external debt for
the low- and middle-income countries had grown an additional 10 percent to $2,742.4
Debt burden ratios (don‚Ä™t confuse these with debt service ratios later in the chapter),
calculated as total external debt divided by total export income, showed a tendency to
fall over the 1990s for all regions except Sub-Saharan Africa. Still, in all regions, the total
external debt-to-exports ratio was higher in 1999 than it had been in 1980 prior to the
outbreak of the debt crisis.
What were the costs of the very high debt burdens of the 1990s? The opportunity
cost of using foreign exchange earnings for debt repayments must be considered. What
might such funds have been used for if they had not been earmarked to repay previously
incurred external debt? To give just one example, Zambia found itself spending in 1994
thirty times more to make its debt payments than it spent on education! Think about
what that might mean for future development in an era of rapidly changing knowledge
By 2005, debt burden ratios had declined significantly everywhere, as debt relief reduced
total debt, and as many economies, especially in Latin America and South Asia, began to
shift their development strategies more toward export substitution. This increased foreign
exchange income inflows as more valuable manufactured goods exports began to replace
the lower-value primary export base that had existed since colonial times. As the growth
rate of total debt declined (the numerator of the debt/export debt burden ratio) and as
export income grew more rapidly (the denominator of the debt burden ratio), the average
debt burden ratio fell dramatically, being everywhere lower than they had been in 1980
(though only marginally so in Sub-Saharan Africa), (see below).
Since the debt burden ratio measures total external debt as a percentage of the total
foreign exchange income earned from exports available to repay external debt or to be
used for other purchases from the rest of the world, these declining ratios signal that
export income had been rising faster than total debt since 1990, a seemingly positive
indicator for the future, at least when looking at regional averages. What happened to
individual countries is another issue, and one we ask you to consider in an exercise at the
end of the chapter.
1980 1990 2000 2005
East Asia 81.8 114.3 81.8 44.1
Latin America 201.8 279.7 178.5 101.7
South Asia 160.5 380.8 181.9 84.3
Sub-Saharan Africa 91.7 219.3 186.6 89.0
Sources: World Bank 1997: 247, Table 17; 2001: 250‚Ä“3, Table 4.15; 2002: 266, Table 4.16; World Development
Indicators 2007, Table 4.16
external borrowing in such circumstances can help a country avoid unnecessary disruptions
to production and employment and can smooth the consumption of imports over the short
term. Once export revenues recover or import expenditures return to normal levels, then
536 The Process of Economic Development
the need for such external borrowing will have ended. Under such circumstances, external
borrowing can help to maintain the level of import purchases and stabilize the economy over
time, thus contributing to greater social welfare.9
For example, if the OPEC petroleum price increases in 1973 had been expected to be
temporary (and since OPEC was a cartel, that might have been a reasonable hypothesis),
then external borrowing to get past that short-term disruption might reasonably have been
justified. However, after a few months had passed and the price of petroleum remained at its
higher level and then was increased again by OPEC in 1974, this justification for external
borrowing to pay for roughly the same physical quantity of imports could no longer be
sustained. Clearly the price increase had become something beyond a temporary disturbance
that was going to go away quickly. OPEC, as a cartel, had not imploded. Any short-term
justification for incurring external debt was no longer tenable.
When the need for external borrowing to finance a current account is expected to be a
recurring long-term likelihood given current or expected levels of imports and exports and
the magnitude of other capital and financial account inflows and outflows, then the decision
to borrow externally needs to be appraised very carefully.
Long-term external debt accumulation must contribute either to foreign exchange savings
or to foreign exchange earnings in the future. In other words, borrowed funds must either
be dedicated to expanding import substitution industries which, in the future, can reduce
future import expenditures, or such borrowing needs to be targeted to the expansion of export
production which increases future foreign exchange earnings.
If external borrowing is to take place, it should be directed only toward those produc-
tive investments that expand the output of tradable goods and services that can generate the
foreign exchange required for repaying the borrowed funds. Obviously export goods are
tradables, but so too are all import substitution commodities. If the output of import substi-
tute industries were not being produced domestically, it would be imported, that is, traded.
Thus investing foreign exchange borrowing in projects to replace imports is a way to save on
foreign exchange needs in the future and to contribute to foreign exchange savings that can
be dedicated to repaying external debt.
Borrowing to finance infrastructure that can contribute to greater export earnings or import
substitution production by lowering costs also could be acceptable. Investments in roads,
communications systems, electricity, water, and perhaps even the legal system might qualify
as means to generate foreign exchange earnings or foreign exchange saving investments and
thus justify external debt accumulation.
The key issue in deciding on the wisdom of external borrowing over the long-term is
determining whether such borrowing is being dedicated to investments that are expected to
generate foreign exchange earnings or foreign exchange savings sufficient to pay down the
external debt undertaken. The issue is not whether external debt accumulation contributes to
the overall economic growth of an economy; that is an insufficient criterion. The question
is whether such external borrowing contributes sufficiently to the growth of the tradable
goods sector to be self-liquidating. If it does, external debt may be advisable; if not, external
debt accumulation is not recommended, since the so-called ‚Äútransformation problem‚ÄĚ of
generating sufficient foreign exchange to repay the debt will not be met, as foreign exchange
borrowing will not be ‚Äútransformed‚ÄĚ into foreign exchange earnings or savings in the future
(World Bank 1985: 48).
External borrowing to finance the expansion of production in non-tradable output ‚Ä“ for
example, the construction of new homes, shopping malls, and hospitals ‚Ä“ may be important
to the well-being of the population. However, investing in these kinds of goods and services
The debt problem and development 537
does not contribute to the ability to repay external debt, since the output created does not
generate foreign exchange earnings or savings. These are goods and services sold and traded
in the internal market only, and they generate funds only in the domestic currency. Therefore,
external borrowing to finance such investments cannot be justified. Neither can many other
types of possible expenditures, such as national defense.
Both import substitution and expanding exports can help to close a trade gap and contribute
to a smaller current account deficit. There may be, nonetheless, some preference for using
external debt to finance export expansion projects over import substitution purposes, since
there is a natural limit to the foreign exchange savings that can be expected over time from
the latter. Not all imports can be replaced by domestic production, so the potential savings of
foreign exchange from import substitution ultimately is finite.
The expected earnings from export expansion, however, can continue to grow over the
future, with no rigid upper-boundary, though there is no absolute guarantee that investing in
export growth will pay off, either. Market conditions can change, new exporters can enter
the same market thus reducing each country‚Ä™s effective demand, and so on (Focus 16.3 illus-
trates the riskiness of the decision to borrow externally, using the case of Mexico as an
example). Still, investing in export expansion, particularly of manufactured goods, is more
likely contribute to the ability to generate the needed foreign exchange to repay the debt, as
well as contributing further to the transformation of the overall economic structure.
FOCUS 16.3 THE MEXICAN DILEMMA
When OPEC raised the price of petroleum in 1973, Mexico was an oil importer despite
having significant domestic oil reserves controlled by the public corporation, PEMEX. One
group within government argued that higher petroleum prices created an opportunity for
Mexico to begin to export oil and generate revenues that could help to finance economic
and social development over the future. Their argument was that external financing was
needed to fund the modernization of the petroleum industry. Then, with increased produc-
tive capacity, petroleum exports and the foreign exchange revenues they generated could
be used to pay back the external debt, while still leaving a surplus to fund economic and
social needs within Mexico.
Others in Mexico feared that this rosy scenario hinged on continued high oil prices. If the
price of petroleum were to decrease significantly in the future, export revenues would be
less than anticipated, cutting into planned projects for social and economic development. If
the price decrease were to be sharp enough, external debt repayment might require
Mexico to export an ever-larger quantity of petroleum (since export income equals the
price of oil multiplied by the quantity of oil exported) in order to be able to earn the needed
foreign exchange to meet the external debt obligations. If this concern sounds reminiscent
of the declining terms of trade debate from back in Chapter 3, it shows you have been
This anti-debt group within and outside of government argued against any expansion
of oil production that needed to be financed by external debt accumulation to be paid
from uncertain future petroleum export income. The fear was that since petroleum is a
non-renewable commodity, that is, non-producible, Mexico would be unable to regulate
the pace at which its oil was used up if the country‚Ä™s oil reserves were ‚Äúpledged‚ÄĚ to repay
external debt obligations. Falling oil prices could trigger a more rapid rate of oil depletion,
as a larger physical quantity of oil would need to be exported at a lower price of oil to earn
the necessary foreign exchange to service the debt, thus threatening future economic
growth and increasing Mexican dependency on others.
538 The Process of Economic Development
The pro-debt forces prevailed, however, and external debt accumulation to renovate the
petroleum sector took place at a rapid pace. Public spending financed by external debt
jumped from 30 percent of GDP in 1978 to nearly 50 percent in 1982. The government‚Ä™s
fiscal deficit more than doubled from 8 percent of GDP in 1980 to 18 percent in 1982.
Mexico‚Ä™s exports came to be dominated by oil. By 1981, oil exports accounted for
69 percent of all exports. And when the price of oil collapsed in the 1980s, the need to
expand the quantity of petroleum exports to service the country‚Ä™s external debt obliga-
tions increased, as more cautionary voices had foreseen.
Mexico‚Ä™s oil ‚Äúpatrimony‚ÄĚ was in danger of being depleted just to repay past external
debt, without leaving much to fuel the social and economic development that had moti-
vated the expansion of oil production in the first instance. It was only as a result of a
change in economic strategy that fueled the growth of manufactured exports as export
substitution finally began that the oil gamble did not result in a more serious crisis.
In recent years, Mexico‚Ä™s manufactured exports have averaged around 80 percent of
total exports, as the overall importance of petroleum exports has waned with the econo-
my‚Ä™s shift to export substitution industrialization. But the dangers of thinking that current
conditions will remain the same when making the decision to borrow externally could not
be clearer than in Mexico‚Ä™s costly venture into expanding its petroleum production.
Sources: World Bank 1985: 63; World Bank Trade Data online
Whether external borrowing is dedicated to expanding export earnings or to creating
import savings, the expected increase in foreign exchange should be sufficient to cover
repayment of the principal (amortization) and interest on the external debt incurred over
the life of the loan. For this to occur, the annual rate of increase in foreign exchange earn-
ings from ‚Äúgrowing‚ÄĚ exports plus the rate of foreign exchange savings from reducing
imports must be greater than the average rate of interest charged on a country‚Ä™s external
As Focus 16.3 suggests, external borrowing should be approached extremely cautiously,
and any guesses about future export prices and future import prices should err on the side of
understating them in attempting to determine the wisdom of accumulating higher levels of
external debt. Countries that find themselves with ‚Äútoo much‚ÄĚ external debt relative to their
ability to repay may find their future growth and development prospects seriously compro-
mised. Thus, in considering whether to borrow to expand exports, the estimation of future
expected export earnings should be based on a presumption that the future prices of exports
will be lower, perhaps significantly lower, than they are in the present, especially for primary
Likewise, in estimating expected future import expenditures in valuing the worth of
investing in import substitution, it should be assumed that future import prices also will
be lower than current import prices. Such discounting will tend to make the standard for
borrowing externally to finance export expansion or import substitution more rigorous, such
that the incentive to borrow is reduced and not based on transitory elements.
There is one further consideration. even when countries do borrow for the right reasons,
such borrowing may be less than effective because of changes in the capital intensity of
production or inefficiency, as Focus 16.4 points out.
External borrowing, adjustment policies, and savings
The foregoing caveats concerning external loans refer to decisions to borrow to finance
persistent current account deficits. Such disequilibria may arise from external events, such as
The debt problem and development 539
FOCUS 16.4 INEFFECTIVE USE OF EXTERNAL DEbT
Even when borrowing is done for the right reasons ‚Ä“ export expansion or import substitu-
tion ‚Ä“ investments funded by external debt still can be inefficiently utilized. In a study of
the Philippines, Argentina, and Morocco, the World Bank found that incremental capital‚Ä“
output ratios (ICORs) in all three countries rose substantially during the period in which
external borrowing was taking place.
For example, Argentina‚Ä™s ICOR increased from 4.4 in 1963‚Ä“72 to 11 over the period
1973‚Ä“81 when there was a rapid build-up of external debt. What a higher ICOR means is
that to generate an additional unit of output, the required quantity of physical investment
rose from 4.4 to 11 units between the two time periods. Thus, new capital investment
was less effective in generating output as a result of an increase in more capital-intensive
production that required more physical capital to create one more unit of GDP, or because
of the less effective use of this physical capital as a result of negligible or even negative
total factor productivity (TFP) rates. Even worse, virtually none of the $35 billion Argentina
borrowed externally between 1976 and 1982 resulted in a net addition to investment, i.e.,
it substituted for investment that likely would have occurred anyway.
The same tendencies were noted in the Philippines, where the ICOR doubled, and in
Morocco, where the ICOR rose from 2.6 in 1965‚Ä“72 to 6.7 in 1979‚Ä“82 as external debt rose
By comparison, Korea‚Ä™s ICOR remained at about 3 as its external debt grew, indicating
sustained efficiency in generating new output from new investment, a reflection of the
region‚Ä™s positive TFP rates considered in Chapter 13. The structural transformations on
the path to expanded industrialization pursued by Korea examined in previous chapters,
combined with good state policy, helped to avoid severe and lingering debt problems from
decreasing returns to physical investment in creating one unit of GDP.
Source: World Bank 1985: 52, 68
the petroleum price increase. But they also may be a reflection of underlying, and often quite
severe, problems and failures of internal economic policy. Policy errors that result in high
levels of inflation and over-valued exchange rates can create situations in which the current
account of the balance of payments is in deficit, requiring a compensating inflow of external
financial resources on the capital and financial account, some of which may be in the form of
external debt owed to private banks or to bilateral or multilateral lending institutions.
At a more fundamental level, a persistent imbalance in the current account may reflect the
failure of an economy to successfully negotiate the series of ‚Äústrategy switches‚ÄĚ in economic
policy that contribute to the necessary structural transformations on the path toward greater
industrialization and diversification of production discussed in Chapters 9‚Ä“11. It is in those
instances, where external financing is used to attempt to maintain the status quo and to avoid
the costs of better economic policy-making, that external debt is economically inadvisable,
though it may well be the preferred political choice.
The Latin American debtor countries followed this path of least resistance, using external
debt to finance current consumption, or military expenditures, or to repay past external debt
obligations. Too little was ploughed into investments that expanded the foreign exchange
earnings or savings needed to service the external debt responsibilities. This had the effect
of perpetuating existing backward economic structures and policies that badly needed to be
changed. In particular, external debt accumulation permitted the continuation and deepening
of import substitution industrialization and the region‚Ä™s inward orientation and the skipping
of the crucial export substitution stage of industrialization that moved the East Asian econo-
mies forward so quickly, as discussed in Chapter 10. The failure to develop the capacity to
export manufactured goods to the world market was reflected in inefficiencies in production,
540 The Process of Economic Development
as measured by both low aggregate economic growth rates and non-existent rates of total
factor productivity, which stifled progress in Latin America after the 1960s.10
The twin deficit and productive borrowing
If external borrowing to finance a current account deficit is properly used to expand the
production of export tradables, then such borrowing may be an important contributor in the
attempt to transform the economic structure. In these cases, external borrowing is not only
justifiable, but such debt, being self-liquidating, can be integral in creating an economy that
is more efficient and more technologically focused by financing needed investments, both
public and private.
Even if a country does not have a current account imbalance requiring inflows of foreign
exchange, external borrowing could still be warranted if used productively. That is, even a
country with a current account surplus may choose to borrow externally to fund warranted
Using the concept of the twin deficit and assuming there is no central government deficit,
the following basic relation must hold assuming, for now, no external debt accumulation:11
Statement 16.1 shows that if savings (S) equals investment (I) then there will be no trade
gap (i.e., no deficit or surplus) and no need for external financing (since exports, X, will equal
imports, M). In a country without access to external sources of financing, the domestic level
of investment will be constrained by domestic savings.
On the reasonable and usual assumption that S = s(Y/L)L, s, the savings rate, is likely to be
smaller the lower per capita income, Y/L, is so low-income countries are likely to generate
low levels of total domestic savings.12 Low levels of domestic saving mean that the bulk of
an economy‚Ä™s production goes to consumption, leaving little left over for investment. Low
levels of investment, including financing for investment in human capital like education,
health care and technology, result in low levels of income per person in the future. Thus,
a vicious cycle of poverty is reinforced, with poor countries remaining poor because they
begin poor, as they are lacking in sufficient capital of all types for expanding productive
investments over the future due to the low level of savings taking place.
However, if domestic savings, Sd, can be supplemented by foreign savings, Sf, via external
borrowing, then total investment can be pushed above what would be achieved from domestic
resources alone (I = Sd + Sf). When this occurs, statement 16.1 becomes:
Sd ‚ą’ I = X ‚ą’ M < 0 (16.2)
since Sd ‚ą’ I = ‚ą’Sf, which is negative for all Sf > 0.
Statement 16.2 shows that for domestic investment to be greater than domestic saving, the
equivalent value of additional (investment) goods must be imported, resulting in an excess
of import expenditures over export earnings.
In other words, foreign borrowing can finance the twin deficit by boosting the level of
domestic investment and simultaneously financing the import of investment goods and other
inputs to production. This creates the possibility of a virtuous cycle of foreign borrowing,
domestic investment, and increases in domestic production. Of course, our admonition that
such borrowing should be channeled toward tradables, be they export production or import
The debt problem and development 541
substitution goods, still applies. If this condition holds, external borrowing can contribute
to higher economic growth rates and to structural transformation in the production process
along the lines suggested in Chapter 10, permitting poorer nations to supplement domestic
resources in short supply with foreign resources.13
The debt service obligation: the real cost of debt repayment
Given that external debt must be repaid using foreign exchange earned from exporting, it is
often convenient to use the ratio of total debt divided by total exports (D/X) as a measure of the
debt burden. We briefly considered the evolution of the debt burden by region in Focus 16.2.
However, the debt service ratio is another measure of the severity of total external debt
that is more often used for assessing the current cost of external debt. This is calculated as
the share of total export income used for repaying principal and interest on the debt. In other
words, it compares total foreign exchange obligations to repay external debt as a percentage
of total foreign exchange earnings from exports. Table 16.2 shows the debt service ratio for
a number of years for the same countries as in the previous table. The 2005 debt burden ratio
is also shown.
Let us first consider Mexico‚Ä™s debt service ratios to see what these mean. In 1980, the
equivalent of nearly half of Mexico‚Ä™s foreign exchange export revenues was required to pay
amortization and interest on the external debt. That left only a bit more than half of export
earnings available for purchasing imports or for other foreign exchange purposes. The debt
service ratio had decreased by 1990 to about a fifth of export income, only to rise again by
2000 to a bit over 30 percent. By 2004, Mexico‚Ä™s debt service ratio had once again fallen to
about 23 percent of foreign exchange export earnings.
The contrast between the years in terms of the actual cost to the Mexican economy of
external debt servicing is striking, however. In 1980, prior to the debt crisis of mid-1982
(discussed in the next section), Mexico was able to borrow foreign exchange from the private
Table 16.2 Debt service ratios and the debt burden
1970 1980 1990 2000 2004 D/X
Argentina 18.2 37.3 37.0 28.5 225.0
Brazil 31.9 63.1 93.6 46.8 134.2
43.1 25.9 24.8 24.2 90.5
9.2 10.6 35.3 1.6 4.0 119.2
C√īte d‚Ä™Ivoire 6.8 38.7 35.4 22.6 6.9 126.6
9.1 13.1 36.9 15.6 6.6 168.9
20.9 9.3 32.7 14.5 18.9 104.4
Kenya 17.1 21.0 35.4 20.9 8.6 114.3
Korea 13.1 19.7 10.8 24.6 10.2 70.1
3.1 6.3 12.6 5.6 7.9 30.6
48.1 30.4 22.9 65.3
Mexico 28.2 20.7
23.6 17.9 23.0 25.2 21.2 140.4
5.0 25.5 7.5 9.7 6.0 307.8
Tanzania 25.9 32.9 12.8 5.3 260.8
Zimbabwe 4.4 3.8 23.1 ‚Ä“ 4.7 240.3
Sources: World Bank 1983: 178‚Ä“9, Table 16; 1987: 236‚Ä“7, Table 18; 1995b: 178‚Ä“9, Table 9, 206‚Ä“7, Table 23; 2001:
258‚Ä“60, Table 4.17; World Development Indicators 2005; World Development Indicators 2007, Table 4.16.
Debt service ratio = ($ amortization + $interest)/$ exports.
542 The Process of Economic Development
banking system not only to pay for its imports but also to pay for its debt servicing obligations.
So even though the equivalent of half of Mexico‚Ä™s export income apparently was absorbed
by debt service in 1980, much of the actual payment on the debt was done by simply ‚Äúrolling
over‚ÄĚ old debt by incurring new debt. This meant that debt servicing in 1980 did not have
a particularly adverse effect on Mexico‚Ä™s ability to import goods and services, since very
little of its export income was used to pay amortization and interest payments. Most of the
country‚Ä™s foreign exchange earnings were available to purchase desired imports or for other
After the debt crisis began in 1982, however, the ability to borrow to repay debt virtually
ended, so that each country‚Ä™s debt service ratio more accurately reflected the real cost of debt
as measured by the use of foreign exchange earnings and, hence, forgone import or other
expenditures. Thus in 1990, something closer to 20 percent of foreign exchange income from
exports was being used by Mexico to service existing external debt. This meant that some-
thing real, in opportunity cost terms, was being given up to service the external debt.
The last column of Table 16.2 shows the total debt-to-export ratio, or the debt burden,
that we considered by regions in Focus 16.2. For Mexico in 2005, the debt burden was
65.3, meaning total external debt was equivalent to 65.3 percent of Mexico‚Ä™s total foreign
exchange earnings from exports. This is a lower debt burden than in 1999, when the D/X
ratio was 108, and almost a third of the 1993 debt burden, when total external debt was 1.75
times total exports (these values are not shown in the table).
Mexico‚Ä™s debt burden has shown a tendency to fall as special attention has been given
to debt reduction measures and, more importantly, as Mexico‚Ä™s exports have risen faster
than new debt has been incurred as export substitution polices have taken hold. By contrast,
Brazil‚Ä™s and Argentina‚Ä™s debt burdens are quite high and were larger than in the early 1990s,
at least partly a reflection of the low level and growth of their export income. This reflects
more fundamental underlying failures to make the necessary structural transformations
in these two large Latin American debtors, including the formation of human capital and
technology acquisition capabilities discussed in previous chapters that could expand export
substitution possibilities. This has handicapped two promising economies in their ability to
make sustained progress.
In contrast to Mexico, which among the Latin American economies has done reasonably
well, consider Korea‚Ä™s debt experience. Between 1980 and 1990, Korea‚Ä™s debt service ratio
fell dramatically, amounting to but slightly more than 10 percent of export income. Then it
rose sharply by 1999 as total accumulated external debt increased rapidly (Table 16.1), at least
partly as a result of the Asian financial crisis of the late 1990s. But by 2004, the debt service
ratio was comfortably back in the 10 percent range. The reasonable level of debt servicing has
been primarily due to Korea‚Ä™s rapid expansion of exports (at the rate of 12.1 percent annually
compared to the growth of external debt of 7.5 percent, 1984‚Ä“2004), which made external
debt repayment easier over time, even following episodes of sudden borrowing when there
was a crisis.
Because of the faster growth of export earnings compared to debt accumulation, Korea‚Ä™s
debt burden is on the decrease, as the adverse short-term impact of the financial crisis of
the late 1990s passes. In 1993, the ratio had been only 46.2 percent, the second-lowest debt
burden among all countries at that time. Still, being able to repay, theoretically at any rate, all
external debt out of one year‚Ä™s foreign exchange export revenues suggests that Korea (and
Malaysia) have managed to avoid the excessive build-up of external debt that plagues other
debtor nations, especially in Latin America, but also in Africa.
Sudan‚Ä™s, Tanzania‚Ä™s, and Zimbabwe‚Ä™s debt burdens are a matter of grave concern, even
The debt problem and development 543
though their debt service ratios are quite low because of extraordinary efforts by the
international community to delay current repayments. The potential future income from
exports to pay for such a level of total external debt is just not there (see Focus 16.5 on
debt relief measures).
The 1980s debt crisis
The accumulation of external debt at the pace of the 1970s certainly should have been seen
as unsustainable. It was based on the availability of funds from OPEC being deposited in
the international banks that were then used to finance the current account deficits of the oil
importers. At some point, this variation of a Ponzi scheme had to come crashing down. The
onset of the international debt crisis is usually dated as beginning when Mexico announced
its decision to suspend scheduled payments on its debt in August 1982. Other countries soon
followed suit. What set off this moratorium on debt obligations that for a time threatened the
stability of the world financial markets?
By mid-1982, the private international banks had begun to dramatically reduce their petro-
dollar recycling to sovereign borrowers as a consequence of a slow-down in the rate of
growth of the international economy. Stringent monetarist policies to reduce inflation intro-
duced by the United States and British central banks under pressure from Presidents Carter
and Reagan in the United States and from the Conservative government in Great Britain had
resulted in sharp recessions that spread quickly through the global economy.14 As income in
the developed countries like the US and the UK declined so too did their import purchases,
including imports from the less-developed economies.
With a decline in export earnings for the oil-importing nations, the private international
banks suddenly decided that sovereign borrowers were no longer the desirable borrowers
they had been judged to be since 1973. After all, everyone knew that the only way external
debt ultimately could be repaid was via foreign exchange earnings obtained from exporting
that exceeded importing. The commercial banks thus quickly acted to reduce their lending
exposure to the debtor economies, as the perceived riskiness of further lending increased.
Since many borrowing nations already had been using new loans to pay their debt-service
obligations and import expenditures, and had dedicated relatively little of the borrowed funds
FOCUS 16.5 THE FIRST DEbT-FOR-NATURE SWAP
The first debt-for-nature swap took place in 1987 and involved Bolivia and a non-govern-
mental organization (NGO) called Conservation International. Conservation International
purchased $650,000 of Bolivia‚Ä™s external debt on the secondary market for $100,000,
a discount of 85 percent. This was swapped for the equivalent of $250,000 of Bolivia‚Ä™s
currency to be used in setting up and operating the Beni Biosphere Reserve to protect
forest land from logging and other destructive practices. Bolivia reduced its external debt
obligation by $650,000 in hard currency terms, but without using foreign exchange to do
so. Instead, via the swap, external debt was retired using domestic currency.
Other countries also have done such swaps. Brazil had $100 million of debt-for-nature
swaps in 1991. Mexico and Costa Rica also have been parties to such transactions. These
swaps have been no panacea for either developing country debt reduction or for protecting
the environment, as the totals were small relative to the total debt of any country. On the
other hand, such swaps are innovative means to try to combine efforts to increase the
level of development and to protect threatened natural resources simultaneously.
Source: Elliott 1994: 55‚Ä“6
544 The Process of Economic Development
to productive uses in tradables that would have saved or earned foreign exchange in future,
when the so-called loan window of the private banks closed, debtor nations faced a daunting
foreign exchange crisis, given the current account deficits being run by so many of them.15
Without access to new loans to finance current account deficits and with finite official
foreign exchange reserves to draw upon, many countries were soon confronted with diffi-
cult decisions. With the global recession rapidly reducing their own export earnings, it was
impossible to both service past debt and continue to import at the same level, given the
sudden loss of access to external funds.
When external borrowing was still an option, it was possible for an economy to have import
expenditures (M) that exceeded export earnings (X) (i.e., X < M). However, when it became
impossible to borrow foreign exchange in the early 1980s, then a country‚Ä™s import spending
was limited to its export earnings, that is, X ‚Č• M. How was the switch from spending more
foreign exchange than was earned to be turned into a situation of earning at least as much or
more foreign exchange than was spent? This transformation occurred primarily by repressing
import spending in the debtor economies, since exports could not be expanded rapidly.
However, any reduction in imports to save on foreign exchange meant a lower current
living standard and lower GDP, particularly when critical inputs to domestic industries were
affected by any cutback. Making matters worse, all foreign exchange to pay debt servicing
now had to be derived from current export earnings or official foreign exchange reserves, as
external borrowing was impossible.
Mexico‚Ä™s announcement of a moratorium on its debt service had the effect of immediately
reducing the size of the current account deficit that required financing by an amount equal
to the sum of the deferred debt servicing. This meant that without having to dedicate any
of its export earnings to debt repayment more goods and services could be imported than if
Mexico‚Ä™s debt service obligations had been met on time. Deferred debt servicing thus saved
on foreign exchange, leaving more for other purposes. Soon, other indebted nations followed
suit, declaring a debt servicing holiday to conserve on their scarce foreign exchange earned
from exporting, choosing to use them for import purchases.
The debt servicing moratorium had the immediate effect of mobilizing the private inter-
national banks and their governments to attempt to find the means to get Mexico and other
nations to resume their debt service payments. This was necessary to minimize the volume
of loans that would be declared ‚Äúbad,‚ÄĚ or non-performing, a situation that threatened many
of the large international private banks with bankruptcy as a result of the excessive lending
levels to some sovereign borrowers. A fundamental defining feature of the 1970s lending
frenzy, as already noted, was the exceptionally high level of private bank debt held by the
largest borrowing nations.16
While it might have been individually rational for each private bank to have ceased lending
as the riskiness of new loans increased with the onset of the global recession at the begin-
ning of the 1980s, it was socially irrational for them all to suspend lending simultaneously.
In fact, it was this lack of coordination of international financial flows ‚Ä“ combined with a
healthy dose of greed on the part of the banks ‚Ä“ that led the private banks to over-lend before
the outbreak of the crisis and then to under-lend when the United States- and United King-
dom-administered global recession resulted in the sharp decrease in world trade after 1980.
In at least partial recognition of this divergence between private and social benefits and
costs, and the seriousness of the market failure problem, an important part of the effort of
the international community was to minimize the damage to the private banking system and
the global economy after the moratorium was declared (Pastor 1987). There thus emerged a
concerted effort by the International Monetary Fund and the United States Treasury to force
The debt problem and development 545
the large private banks to initiate so-called involuntary lending to the major debtor countries,
i.e., to open the channels of lending yet again as a way to avoid collapse of the international
financial system. In effect, as a condition of being repaid and avoiding bankruptcy, the banks
would provide new loans to meet the debt servicing requirements of the debtor economies.
In making such loans and in providing other concessions to the debtor nations ‚Ä“ such as
lower interest rates and longer repayment schedules, albeit without much enthusiasm ‚Ä“ the
larger private banks avoided the worst effects that a full-scale default would have implied.
The banks provided ‚Äúbridge loans‚ÄĚ that made continued repayment to the large private
lenders possible, and they thus avoided technical defaults by the debtor economies. Many
smaller banks were, however, left out of the international reorganization deals, and quite a
few collapsed when their loans went unpaid.
Longer-term efforts to overcome the debt crisis17
The initial efforts of the international community to overcome the 1982 debt crisis focused on
measures that might enable potentially defaulting countries to continue to service their debt
obligations without unduly affecting long-term economic growth. These measures included
the involuntary lending by the banks discussed above. There were also numerous initia-
tives to lengthen the maturities of commercial loans, to reduce interest rates charged and to
capitalize overdue payments by adding them to the principal value of the loans. Some write-
downs, or cancellations, of private bank loans occurred, but these have not been particularly
significant. Turning loans into long-term bonds, even perpetual bonds never requiring the
repayment of the principal, was an early proposal still worthy of more widespread applica-
tion, especially for the most deeply indebted economies (World Bank 1985: 29). As we saw
from Table 16.1, for many countries, external debt has continued to increase.
Multilateral (e.g., World Bank and IMF loans) and bilateral (e.g., government-to-govern-
ment) debt has been somewhat easier to reschedule or even cancel. Various rounds of nego-
tiations of the so-called Paris Club had some success in reducing non-commercial debt of the
twenty-five to thirty poorest of the most indebted nations (having GDP of less than $500 or
debt burden ratios exceeding 350 percent), most of which have been in Sub-Saharan Africa.
Under the 1994 Naples terms of the Paris Club discussion, for example, up to 67 percent of
non-commercial public external debt was potentially eligible for long-term rescheduling and
even, in some instances, cancellation (UNCTAD 1995: 36‚Ä“9). The goal has been to reduce
the debt service ratios of the poorest debtors to below 20 percent. However, debt reduction or
extensive stretching-out of maturities is not enough. It is also necessary to correct whatever
it is that resulted in excessive debt accumulation, and for most countries that begins with a
failure to have properly initiated and carried through the required structural transformations
discussed in Chapters 9‚Ä“11.
Another type of debt reduction measure that was popular for a time was the debt swap. In a
debt swap, an indebted country trades something of value to a holder of its debt in return for
a reduction or even cancellation of some of the country‚Ä™s external debt. For example, a debt-
for-equity swap might involve the holder of Mexican debt with a value of, say, $1 million
exchanging that debt with the Mexican government for ownership in a newly privatized,
formerly state-owned, company. The holder of the Mexican debt might receive, for example,
an equity value in the company equivalent to $1.2 million, though that equity would now be
denominated in pesos, not in dollars. It is clear that there were potential gains to both parties
in such transactions. The holder of Mexican debt with a face value of $1 million would ‚Äúbuy‚ÄĚ
$1.2 million worth of equity in a Mexican company at a discount (maybe substantially less
546 The Process of Economic Development
than the face value of the debt). The Mexican government is able to retire $1 million worth
of external debt that had been denominated in dollars, thus reducing its future debt servicing
requirements and the outflow of foreign exchange.
Other kinds of swaps also were completed. Debt-for-nature swaps were used to encourage
countries to set aside rainforests or other land areas as protected reserves. In these swaps,
the holder of external debt might be an organization like the World Wildlife Fund (WWF) or
some other non-governmental organization (NGO) with an interest in preserving the natural
environment. How would such a group come to be a holder of, say, Costa Rican debt that
could be swapped for rainforest preservation? They most likely purchased this debt on the
secondary debt market. The secondary debt market is a ‚Äúdiscount‚ÄĚ market for sovereign debt
instruments. Banks or any institution holding sovereign external debt can trade their debt to
others willing to purchase it.
Chase Manhattan Bank, for example, could decide that it wishes to remove external debt
with a face value of $20 million from its portfolio of loans because of concern over the likeli-
hood of repayment or to reduce its exposure in the external debt market or any other reason.
In the secondary market in 1989, for example, the discount on such Brazilian debt was in
the neighborhood of 70 percent, so the WWF could have purchased $20 million worth of
Brazilian debt instruments for about $6 million. Then, the WWF could ‚Äúswap‚ÄĚ this debt with
the Brazilian government for an agreement that sets aside the equivalent of, say, $10 million
worth of Brazilian rainforest from future economic development by transferring ownership
to a trust, to a government agency, or even to the WWF. In this way, the WWF is able to
protect $10 million worth of Amazonian rainforest from overuse at a cost to its members
of $6 million. The Brazilian government reduces its external indebtedness at a 50 percent
discount (by giving up the equivalent of $10 million of Brazilian forest to retire $20 million
of external debt), though the actual cost may be significantly less than this, since there is no
outflow of foreign exchange associated with this swap (see Focus 16.5 on the first such debt
for nature swap).
There was even some hope, for a time, that approaches such as the Brady Plan, proposed
in 1989, might actually lead to a voluntary reduction of the external debt burden of the most
deeply indebted nations as commercial banks and other institutions were encouraged to write
down their debt holdings. That did not happen to any great extent, however, and many coun-
tries continue to be saddled with large debt burdens that make the structural transformations
required for further development even more difficult to achieve.
Debt overhang and future economic growth
For many countries in Latin America and Sub-Saharan Africa, poor economic policy deci-
sion-making in the past led to further bad decisions in the 1970s to accumulate large external
debts so as to finance unsustainable current account deficits. All too often, external debt was
not used to promote the adjustment of the economy to a more productive economic structure
but was used to maintain the status quo and inequitable structures and supporting policies.
Further, much of the accumulation of 1970s external debt was undertaken by non-democratic
governments that overspent and wasted public monies during their tenure in power.
In many of the indebted countries, particularly in Latin America, democratic govern-
ments emerged in the mid- to late 1980s with reformist and more democratic agendas, as
totalitarian regimes collapsed across the region and around the world. These were govern-
ments, often at the urging and with the assistance of the IMF and the World Bank, interested
in fundamentally altering the structure of their economies by making them more efficient,
The debt problem and development 547
more technologically-based, and more independent. However, the debt overhang of accumu-
lated external debt and its repayment acted as a brake on efforts at transformation, making
economic growth substantially more difficult and costly to attain and more protracted than it
needed to have been (Sachs 1989).
Debt overhang can adversely affect investment decisions of potential investors, both
domestic and foreign. They may fear higher taxes or periodic domestic economic recessions
will be necessary to find the funds required to repay the external debt obligations. Such fears
may discourage productive investment from taking place, thus reducing economic growth
rates (on debt overhang, see Chowdhury (1994); Cohen (1995)). Table 16.3 provides some
indirect evidence of the impact of external debt accumulation and debt overhang on invest-
ment levels after 1980 for various economies.
In Argentina, Brazil, Mexico, and a number of African economies, the decrease in gross
investment from 1980 to 1990 is evident and indicative of the costs arising from the effects
of the debt crisis. Argentina in 2005, for example, had an investment rate below the level that
had been reached in 1970. Korea, Chile, and India have managed to increase their invest-
ment rates, thus fueling higher economic growth rates, though the effects of the 1997 Asian
financial crisis was still being felt in Korea and Malaysia in 2005. As seen in Table 16.2, the
burden of debt (D/X) in those countries is now not so severe.
Also apparent from the data for many of the African countries is the instability of invest-
ment rates. In some years, investment rates have been respectable, but they seem not to be
sustainable. The recovery in investment in the Congo is probably due at least partly to the
fact that, as for Mexico, the Congo is now an oil exporter. For the severely indebted econo-
mies, particularly those which remain primary product exporters, like Argentina and C√īte
d‚Ä™Ivoire at more than 70 percent, debt overhang continues to make any desire by govern-
ment and the private sector to initiate the desirable structural transformations toward a more
sustainable, productive, and efficient economy more difficult as valuable foreign exchange is
drained to pay external debt obligations.
In one comprehensive study, the effect of debt overhang on economic growth was esti-
mated to become negative, on average, when the debt burden exceeded 160‚Ä“170 percent of
exports and 35‚Ä“40 percent of GDP (Pattillo, Poirson, and Ricci 2002). From Table 16.2, that
Table 16.3 Gross capital formation (as percentage of GDP)
1965 1970 1980 1985 1990 2000 2005
Argentina 19 24 25 18 14 16 21.5
Brazil 25 21 23 19 21 20.6
15 19 21 17 25 23 23.0
24 36 30 16 24 24.1
C√īte d‚Ä™Ivoire 13 12 10.7
22 22 27 7
18 14 6 10 14 24 29.0
18 17 21 24 25 24 33.4
Kenya 14 24 25 13 16.8
Korea 15 25 32 30 38 29 30.1
25 32 26 19.9
Malaysia 20 20 27
23 21 23 23 21.8
Mexico 22 27
21 16 18 18 19 16 16.8
10 13 15 9 14 23.3
Tanzania 15 23 ‚Ä“ 17 13 18.9
Sources: World Bank 1982: 118‚Ä“19, Table 5; World Development Indicators 2002 and 2007.
548 The Process of Economic Development
would include Argentina, Ghana, Sudan, Tanzania, and Zimbabwe, with Brazil and Pakistan
very close to having a D/X ratio in that range. However, the marginal negative effects of
debt overhang were manifest at D/X ratios equal to half the average, meaning in the 80‚Ä“85
percent range. By that measure, all the economies in Table 16.2, with the exceptions of
Korea, Malaysia, and Mexico, had some predicted negative impact on the economy from
debt overhang. The authors also found that debt overhang affected not just investment rates
but also total factor productivity (TFP) rates, i.e., intensive economic growth, thus slowing
Looking at the almost forty so-called ‚Äúheavily indebted poor countries‚ÄĚ (HIPCs), their
investment rates in 2005 averaged 20.9 percent compared to 28.6 for all low-income econ-
omies and 27.1 percent for all low- and middle-income economies (WDI online 2007).
However, as some economists have pointed out, there are likely other structural factors ‚Ä“ bad
policy decisions, poor infrastructure, a lack of fundamental structural transformation ‚Ä“ besides
debt overhang that more likely explain the low investment rates for many of the HIPCs. Still,
high debt burdens do not help, even if they are not the major factor in slowing economic and
The social effects of servicing debt also can be quite severe. A 1996 Oxfam report
For less than is currently being spent on debt, it would be possible by the year 2000 to
make social investments which would save the lives of around 21 million African chil-
dren, and provide 90 million girls with access to primary education.
The amount spent by governments in Sub-Saharan Africa to service debt amounts to four
times what is spent on health care and exceeds the total amount spent on primary education
and primary health care combined. It is the poorest debtors, particularly those in Africa, such
as Mozambique and Zambia, which find that their debt payments greatly exceed spending
on social infrastructure.18
Some way must be found to relieve the pressure of debt overhang, perhaps through new
forms of lending that convert old debt into perpetual bonds never requiring repayment of the
principal. This will at least open the possibility that such economies will not be bound by
poor policy decisions from the past. This step is all the more urgent, because many of these
loans were undertaken by non-democratic governments under which few in the population
Summary and conclusions
Far too many economies accumulated external debt during the 1970s for the wrong reasons.
Mostly, the rapid build-up of debt was a response to OPEC‚Ä™s increases in oil prices, which
resulted in the demand for borrowing to finance larger current account deficits. Too often,
this external debt was not used productively, a reflection of the fact that many of the major
borrowers, especially in Latin America, had failed to transform their economies in the ways
we considered in earlier chapters. In particular, economies with inefficient industrial produc-
tion and disappointing progress in shifting from a primary product export base to a secondary
export structure were more likely to accumulate ‚Äútoo much‚ÄĚ external debt and find repay-
ment difficult and costly for economic growth. The fact that much of the external debt was
owed to private commercial banks who clearly over-lent complicated matters when the debt
crisis began in 1982.
The debt problem and development 549
Taking a longer-term view, the debt crisis had some positive effects. Because of pressures
from the international community to change the way their economies operated, not all of which
were viewed at the time as helpful, many non-democratic governments disappeared and were
replaced by the return, or the beginning, of democratic political processes. With such political
openings and the continued pressure to reduce barriers to trade in international agreements
(discussed in the next chapter), more economies, especially in Latin America, but also in Asia,
experienced important structural changes imposed by international competition. One conse-
quence of this has been the growth in manufactured goods exports in many economies, as
export substitution policies took hold. This has helped to decrease the importance of primary
product exports and made it easier for countries to service their external debts, as export income
tends to grow faster with the shift toward secondary and other non-traditional exports.
Many economies continue to suffer from some degree of debt overhang. Whether it reduces
investment or productivity or cuts into social or other spending, there is some measurable
adverse effect on these economies. Given the circumstances under which much external debt
was accumulated, in particular by non-democratic regimes, there continues to be a pressing
economic and moral need to minimize the adverse impact of debt on current governments
intent on fomenting positive transformations of their economic structures.
Questions and exercises
1 Carefully define external debt. How is it different from the internal debt of an economy?
2 Why do countries incur external debt?
3 For what purposes can the accumulation of external debt be justified?
4 What are two or three ‚Äúbad‚ÄĚ reasons for incurring external debt other than those listed
in the chapter?
5 How is external debt repaid, i.e., where do the funds come from to repay external debt?
6 Table 16.1 shows the total external debt for a few nations. However, in comparing total
debt among nations, such a gross comparison may be a bit deceptive. Countries with
larger populations may be better able to repay a given amount of debt than a country
with a smaller population. First, using the total debt values from Table 16.1, rank the
countries from 1 to 14, using 1 for the country with the highest total debt and 14 for the
country with the lowest total debt.
Per capita external debt, 2005
Total external debt ranking Population Debt per person Ranking
550 The Process of Economic Development
Then, find the total population for each country from www.worldbank.org or some
other source and calculate per capita external debt. Then rank the countries by debt per
person, using 1 for the country with the highest debt per person and 14 for the country
with the lowest debt per capita. How do the rankings for total debt differ from the rank-
ings for debt per capita?
7 Imagine a country with total external debt of $22,000 million, on which an average rate
of interest of 8.7 percent is charged. Its exports are currently equal to $31,000 million and
are growing at a rate of 4.5 percent per year. Calculate the current debt/export ratio and,
assuming no new external debt accumulation, the debt/export ratio in five years‚Ä™ time.
8 What effect does a deterioration in a country‚Ä™s terms of trade have on its ability to
service its external debt obligations? What effect does a devaluation or depreciation of
a country‚Ä™s currency have on its ability to service its external debt obligations? If you
can, use some simple numerical calculations to show these effects. (For example, when
the value of the Mexican peso fell from roughly 3 pesos:US $1 to 6 pesos:US $1 in early
1995, did this depreciation make repayment of Mexico‚Ä™s debt easier or more difficult?
Were more or fewer exports, in physical terms, required for a fixed amount of debt
9 For a country that interests you and for the region in which the country you chose is
located and for the low- and middle-income countries, use the table below to input
the requested information for two years, using data for, say, 1990 and the most current
year. You can find the data for parts a‚Ä“c (below) at http://www.worldbank.org. Click on
‚ÄúData,‚ÄĚ then ‚ÄúData by Topic‚ÄĚ and then choose ‚ÄúDebt.‚ÄĚ For d go to http://hdr.undp.org/
reports and then in the left-hand column click on ‚ÄúHDR,‚ÄĚ then click on ‚ÄúChapters‚ÄĚ and
then choose ‚ÄúTables‚ÄĚ (you will have to do a search on ‚Äúdebt service‚ÄĚ to find exactly
where the data is located). Find and record the following for two years:
a total external debt;
b long-term debt as a share (i.e., percentage) of total debt (you will have to calculate
c by what percentage the total external debt of the low- and middle-income countries
has increased between the two years;
d debt service ratio (using exports as the base, not GDP) for the two years. Has your
country‚Ä™s situation improved?
For each of these items, briefly (in a sentence or two) explain what these specific
values for your country mean and how your country measures up to the region to which
your country belongs and compared to all low- and middle-income economies.
Low- and middle-income countries
10 Last year, Indonesia had to repay $3.45 billion in interest on its total external debt of
$66.7 billion. It also had to repay principal (amortization) of $2.81 billion. Indonesia‚Ä™s
total imports last year were $45.13 billion and its exports were $46.67 billion. From this
data, calculate Indonesia‚Ä™s debt service ratio. Show your work.
The debt problem and development 551
11 What are some of the opportunity costs countries might face when repaying external
debt, particularly when debt was accumulated for the wrong reasons?
1 This is a political precondition that we have, admittedly, not specifically addressed, not because we
think it unimportant, but because it would take us too far afield from our current inquiry. Unfortu-
nately, it would appear that in many circumstances governing elites are not truly concerned with
improving economic and social conditions for a broad range of the population. They often seem to
be more interested in consolidating specific gains for a narrow segment of a ruling elite of which
they are a part. Under such conditions, the economic know-how about development will be less
immediately important than are the necessary political changes which can strengthen democracy
and participation in the decision-making process of the country.
In some instances, political change will need to be quite revolutionary, certainly in the sense
of displacing former centres of political and economic power, if not also literally in the sense of
overthrowing corrupt and non-democratic regimes. Such fundamental political changes preceded
the rapid progress observed in South Korea and Taiwan after the 1950s. In other countries with
entrenched ruling classes wielding economic and political power, the nullification of powerful
interests may be as important for the future as are the proper exchange rate and human capital
2 External debt is borrowing denominated in a foreign currency, typically a hard or stable interna-
tional currency like the US dollar or the euro. We discussed such external borrowing in the previous
chapter in the context of economies that borrow to finance a current account deficit in their balance
3 Currently, the membership of OPEC includes: Algeria (1969), Angola (2007), Indonesia (1962), Iran
(1960), Iraq (1960), Kuwait (1960), Libya (1962), Nigeria (1971), Qatar (1961), Saudi Arabia (1960),
the United Arab Emirates (1967), and Venezuela (1960). The date of membership is shown in paren-
theses. Ecuador was a member of OPEC from 1973 to 1992 and Gabon from 1975 to 1994. OPEC
itself was founded in 1960 at the Baghdad Conference by the five founding members whose member-
ship year is 1960. See http://www.opec.org/aboutus/ for more details, including current prices of oil.
4 US dollars were the key currency for external debt. Anywhere from 65 percent to more than 75
percent of external public debt was denominated in dollars over the period 1974 to 1983 (World
Bank 1985: 22). External debt is incurred when governments or businesses borrow from foreign
governments, from foreign private banks, from foreign businesses, from individuals in other coun-
tries, or from a multilateral lending agency, such as the World Bank or the International Monetary
Fund. external debt can be repaid only by earning the necessary foreign exchange, that is, by
exporting goods and services.
By contrast, internal debt arising, for example, from the central government‚Ä™s need to borrow to
cover a budget deficit, is most often denominated in the country‚Ä™s own currency. While the possi-
bility, and the danger, of simply printing money to repay an internal debt exists, thus making repay-
ment assured, such a possibility is not available for servicing external debt payments. external debt
repayment requires that foreign exchange in excess of expenditures be earned from the rest of the
world; printing money to repay external debt is not an option.
5 Sovereign borrowers were thought to be better risks than other borrowers. The thinking of the
private banking community was that, as independent and sovereign countries, the oil-importing
borrowers would always be able to repay, on the assumption that countries ‚Äúdo not go bankrupt.‚ÄĚ Of
course sovereign borrowers were different from other borrowers in another significant sense, too.
They did not provide any collateral to the private banks when they borrowed as other borrowers,
like businesses or households, do.
As we shall see, the banks made a logical error. While it may be true that sovereign nations
do not go bankrupt in the usual sense of the term, they certainly can decide to not make on-time
payments on loans (a moratorium) or even at all (a default). The international banking system‚Ä™s
thinking also demonstrates its lack of ‚Äúmemory.‚ÄĚ Very similar banking crises had erupted in the
1890s and in the 1930s with almost the same cast of bad debtors, particularly the larger Latin
American countries (see Stallings 1988). It might be worth remembering a dictum, appropriately
552 The Process of Economic Development
updated, attributed to economist John Maynard Keynes, a warning the international banks appar-
ently forgot: if you owe the bank $100,000, you have a problem. If you owe the bank $100 million,
the bank has a problem.
6 Just prior to the outbreak of the debt crisis, in 1982, South Korea was the third-largest debtor nation,
at least in terms of total external debt, after Brazil and Mexico.
7 In 1974, 18.4 percent of all public external debt was in floating interest rate loans; by 1982, 51.2
percent of public external debt had been contracted at variable rates of interest (World Bank
1985: 21, Table 2.4).
8 We are here concerned with the practical arguments for incurring external debt, as opposed to the
theoretical rationales often found in the economics literature, particularly those concerned with
the free flow of capital between nations. (We are also concerned with the issue of capital inflows
resulting from borrowing, as distinct from capital inflows that result from foreign aid or from multi-
national direct foreign investments discussed in Chapters 14 and 17.)
For example, it is often argued that when financial and physical capital flow to less-developed
nations from more-developed nations, these contribute to an increase in the level of world effi-
ciency, as capital moves from regions with lower rates of return, that is, more-developed economies
with relatively large stocks of capital, to regions with higher rates of return, that is, the less-devel-
oped nations with smaller stocks of capital. In this way, it is argued, external sources of savings can
add to internal savings, thus permitting lower-income countries to grow more rapidly.
These efficiency and mobilization-of-savings arguments are often put forward as compel-
ling reasons for countries to rapidly open the capital and financial account of their balances of
payments accounts, that is, to allow the free flow of financial capital within the international
economy without government interference with such flows. However, as Stiglitz (1993) has
argued, the flow of financial capital is not at all like the flow of goods, and any market imperfec-
tions can result in too much or too little movement of capital. In fact, Stiglitz makes the case
that when financial markets are imperfect, government oversight of capital flows can increase
economic efficiency. Recognizing, then, the complexities of external capital flows, we are consid-
ering the rationale for such borrowing, assuming an imperfect world with imperfect information,
that is, a Stiglitz-type world.
9 Alternatively, it might well be argued that one of the reasons countries hold foreign exchange
reserves is to have the ability to undertake precisely such import consumption smoothing.
Borrowing for consumption smoothing is a situation when a short-term need to borrow exter-
nally should be roughly matched on the other side of the business cycle by an excess of foreign
exchange earnings over foreign exchange spending such that a surplus on the current account
permits repayment of previously accumulated external debt obligations.
10 The political economy of the problem of external debt accumulation is even more complex than
shown here. At least a part of the reason for the twin deficit discussed in the next section and for
a persistent current account imbalance in many less-developed nations, and certainly many Latin
American economies, is related to income inequality. A narrow but wealthy stratum of the popula-
tion has a high propensity to import. The demand of this elite for imported consumer goods and,
indirectly, for imported inputs of domestic capital-intensive industries, adds to the import bill and
reduces the share of any export earnings that might be dedicated to other uses.
One possibility for dealing with recurrent current account deficits might, then, involve a tax on
high-income families, which will reduce import demand and the external borrowing requirement.
Such tax revenues could provide a source of funds for financing the structural transformation and
the expansion of export substitution production, further reducing external borrowing requirements.
11 This result can be derived from a simple rearrangement of the basic macroeconomic identity
where Y = C + I + (G ‚ą’ T) + (X ‚ą’ M). If G ‚ą’ T = 0, i.e., there is no central government deficit, then
we can rewrite the equation as Y ‚ą’ C ‚ą’ I = X ‚ą’ M. Since saving S = Y ‚ą’ C, we can further simplify
to S ‚ą’ I = X ‚ą’ M, which is statement 16.1 in the text.
12 S is total savings, Y is total national income (say, GDP), L is total population, Y/L is per capita income,
and s, which is the proportion of income saved (‚Äúthe savings rate‚ÄĚ), has a value of 0 < s < 1.
Thus this equation states that domestic savings is equal to (determined by) the percent of income
saved times the income per person times the number of persons in the economy. Obviously if s =
0 or is close to zero, the total level of savings will be zero (or close to it). This means there can
be no domestic investment (since S = 0 = I) and no expected economic growth in the most simple
economic model, as there will be no new physical capital being created.
The debt problem and development 553
13 The full twin deficit equation, (S ‚ą’ I) + (T ‚ą’ G) = X ‚ą’ M, demonstrates another possible cause of the
need to borrow externally. If the central government runs a budget deficit such that T ‚ą’ G < 0, then,
assuming S ‚ą’ I = 0 or S ‚ą’ I < 0, an external borrowing requirement is also created by the internal,
domestic fiscal deficit.
This reinforces the need for prudent government finance and oversight of internal macroeco-
nomic policy. Internal debt can lead to external debt accumulation. On the other hand, government
may find it wise to borrow externally when loanable funds are short at home, but only if such
borrowing meets the same requirements of expanding tradables in the future. Such state spending
may be directed to a broader range of investments which can have such an effect: education,
research and development, international marketing research, and so on.
14 Basically, by reducing growth in the money supply, interest rates were pushed upward dramati-
cally, thus discouraging borrowing and investment. This induced a slow-down in economic activity
which resulted in a slower pace of inflation as aggregate demand fell.
15 In 1981, all of the countries listed in Tables 16.1 and 16.2 had substantially larger current account
deficits than had prevailed in 1970 prior to the OPEC price increase. For example, Mexico‚Ä™s current
account deficit had risen from $1,068 million in 1970 to $12,933 million in 1981; Chile‚Ä™s from $91
million to $4,814 million; Kenya‚Ä™s from $49 million to $736 million (World Bank 1983: 74‚Ä“5,
Table 14). Part of this was due to higher oil costs. Part, however, was the consequence of the larger
external debt service obligations to repay interest and principal that created an added outflow of
foreign exchange on the current account.
External debt incurred to finance current account deficits thus added to future current account
deficit financing needs as a result of the outflow of interest and principal repayment required
for debt servicing. In many countries, particularly in Latin America, with weak or non-existent
restrictions on movements of financial assets, capital flight also seriously exacerbated the need
for external borrowing beyond that reflected in the current account imbalance alone, as investors
converted their domestic currency to dollars and moved them off-shore.
16 This was particularly true for the Latin American debtor nations and in East Asia. For most African
economies and South Asian borrowers, the bulk of their external debt had been provided by multi-
lateral agencies such as the World Bank or the International Monetary Fund, or by other govern-
ments at concessional rates of interest and with easier repayment schedules. In 1980, 74.4 percent
of South Asia‚Ä™s external debt was concessional; 27.0 percent of Sub-Saharan Africa‚Ä™s was conces-
sional, but only 4.4 percent of external debt in Latin America was concessional (World Bank 1995b:
206‚Ä“7, Table 23).
The world recession adversely affected the African and South Asian countries‚Ä™ ability to
repay as well. However, the effect of any default on multinational lending agencies or on other
governments that had extended concessional loans was quite different from a default impacting
on private banking institutions‚Ä™ balance sheets and accounting rules. The debt crisis set off by
Mexico‚Ä™s and other debtors‚Ä™ moratorium was a real crisis for the international financial system,
since it threatened the stability and even the possibility of survival of several major private
banks. If this crisis had not been solved quickly, the impact on the world economy could have
been quite severe (see Felix (1987) for a historical perspective on earlier debt crises affecting
17 For a readable and informative early overview on external debt reduction, see ‚ÄúSymposium‚ÄĚ
18 For example, between 1990 and 1993, Mozambique was able to meet only about 10 percent of its
scheduled debt repayments, equal to about $70 million per year. Yet this amount alone would have
been sufficient to pay for ten times the number of textbooks required for all the country‚Ä™s primary
Amsden, Alice H. 2001. The Rise of ‚Äúthe Rest‚ÄĚ: Challenges to the West from Late-Industrializing
Economies. Oxford: Oxford University Press.
Chowdhury, Khorshed. 1994. ‚ÄúA Structural Analysis of External Debt and Economic Growth: Some
Evidence from Selected Countries in Asia and the Pacific,‚ÄĚ Applied Economics 26 (December):
554 The Process of Economic Development
Cohen, Daniel. 1995. ‚ÄúLarge External Debt and (Slow) Domestic Growth: A Theoretical Analysis,‚ÄĚ
Journal of Economic Dynamics and Control 19 (July): 1141‚Ä“63.
Devlin, Robert. 1989. Debt and Crisis in Latin America: The Supply Side of the Story. Princeton: Prin-
ceton University Press.
Elliott, Jennifer A. 1994. An Introduction to Sustainable Development. London: Routledge.
Felix, David. 1987. ‚ÄúAlternative Outcomes of the Latin American Debt Crisis: Lessons from the Past,‚ÄĚ
Latin American Research Review 22(2): 3‚Ä“46.
Ffrench-Davis, Ricardo and Stephany Griffith-Jones (eds.). 1995. Coping with Capital Surges: The
Return of Finance to Latin America. Boulder, CO, and London: Lynne Rienner Publishers.
IMF (International Monetary Fund). 1995. World Economic Outlook. Washington, D.C.: IMF.
Pastor, Robert A. (ed.) 1987. Latin America‚Ä™s Debt Crisis: Adjusting to the Past or Planning for the
Future. Boulder, CO, and London: Lynne Rienner Publishers.
Pattillo, Catherine, H√©l√®ne Poirson and Luca Ricci. 2002. ‚ÄúExternal Debt and Growth,‚ÄĚ Finance and
Development 39 (June): 35‚Ä“8.
Sachs, Jeffrey. 1989. ‚ÄúThe Debt Overhang of Developing Countries,‚ÄĚ pp. 80‚Ä“102 in G.A. Calvo et al.
(eds.), Debt Stabilization and Development. Oxford: Oxford University Press.
Stallings, Barbara. 1988. Banker to the Third World: U.S. Portfolio Investment in Latin America, 1900‚Ä“
1986. Berkeley: University of California Press.
Stiglitz, Joseph. 1993. ‚ÄúThe Role of the State in Financial Markets,‚ÄĚ Proceedings of the World Bank
Annual Conference on Development Economics, vol. 2. Washington, D.C.: World Bank.
‚ÄúSymposium: New Institutions for Developing Country Debt.‚ÄĚ 1990. The Journal of Economic
Perspectives 4 (Winter): 3‚Ä“56.
UNCTAD (United Nations Conference on Trade and Development). 1995. Trade and Development
Report 1995. Paris: UNCTAD.
Vernon, Raymond (ed.). 1987. The Oil Crisis. New York: W.W. Norton & Co.
Wee, Herman van der. 1976. Prosperity and Upheaval: The World Economy, 1945‚Ä“1980. Berkeley:
University of California Press.
World Bank. 1982. World Development Report 1982. Oxford: Oxford University Press.
‚Ä”‚Ä”. 1983. World Development Report 1983. Oxford: Oxford University Press.
‚Ä”‚Ä”. 1985. World Development Report 1985. Oxford: Oxford University Press.
‚Ä”‚Ä”. 1987. World Development Report 1987. Oxford: Oxford University Press.
‚Ä”‚Ä”. 1995a. Annual Report 1995. Washington, D.C.: World Bank.
‚Ä”‚Ä”. 1995b. World Development Report 1995. Oxford: Oxford University Press.
‚Ä”‚Ä”. 1997. World Development Report 1997. Oxford: Oxford University Press.
‚Ä”‚Ä”. 2001. World Development Indicators 2001. Washington, D.C.: World Bank.
‚Ä”‚Ä”. 2002. World Development Indicators 2002. Washington, D.C.: World Bank.
Zanoyan, Vaban. 1995. ‚ÄúAfter the Oil Boom,‚ÄĚ Foreign Affairs 74 (November/December): 2‚Ä“7.
17 International institutional linkages
The International Monetary Fund, the World
Bank, and foreign aid
after reading and studying this chapter you should better understand:
‚ÄĘ the functions and evolution of the International Monetary Fund and the World
Bank and their lending programs;
‚ÄĘ what an IMF stand-by loan is and its purpose;
‚ÄĘ the theory supporting, and the purpose of, IMF austerity and adjustment
‚ÄĘ the effectiveness of IMF austerity and adjustment programs;
‚ÄĘ the difference between World Bank project loans and structural adjustment loans
‚ÄĘ Poverty Reduction Strategy Papers (PRSPs) and pro-poor growth
‚ÄĘ the focus and limitations of foreign aid;
‚ÄĘ the nature of donor bias in aid giving.
As we have seen in the previous chapters, developing nations have to make a wide range of
choices regarding their development strategies. For sustainable development, we have seen
that, in the final analysis, countries must draw primarily upon their own resources and capa-
bilities. However, since virtually all less-developed nations are members of the IMF and the
World Bank (IBRD, the International Bank for Reconstruction and Development), and since
almost all of the poorest and some of the not-so-poor nations draw significant supplements
to their savings and production capabilities from foreign aid, it is necessary for every student
of economic development to acquire a basic understanding of the role of these institutions in
the development process.1
When sovereign nations turn to the multilateral institutions such as the IMF and the World
Bank, or when they accept foreign aid, they then are able to extend their production capa-
bilities by supplementing domestic savings and investment (or consumption) with foreign
resources. But while such access creates an opportunity, it also presents a challenge to the
developing nations, since the international institutions never lend or grant funds without
also attempting to influence the course of events and the economic dynamics of the less-
developed nations. When international institutional linkages improve on the overall devel-
opmental potential of the recipient nation, there is little reason for concern. Unfortunately,
in the opinion of virtually all observers of aid, including the lending institutions themselves,
556 The Process of Economic Development
this fortuitous outcome has too rarely been achieved. Consequently, the role and effects of
international institutional linkages have long been a subject of much debate and sometimes
It is often difficult to penetrate to the core of this debate, because the recipient nation may
find it convenient to exaggerate the impact of the international institutions on their develop-
ment trajectory in order to avert criticism of its own policies. Meanwhile, the lending and
donor agencies have operated with varying degrees of secrecy, making it extremely difficult
for development economists to evaluate objectively the impact of these international institu-
tional linkages. Of all the various international institutions involved in development issues,
the IMF is by far the most opaque in its operations. We will turn to this entity first, then to the
World Bank, and finally to bilateral foreign aid. Little specific attention will be paid to the
regional development banks, the main ones being the InterAmerican Development Bank
(IDB), the Asian Development Bank (ADB), and the African Development Bank (AfDB).
These regional banks are important, and they function much as does the World Bank, but
with a mandate limiting their activity to a geographic region.
Both the IMF (or ‚Äúthe Fund‚ÄĚ) and the World Bank were conceived at the Bretton Woods
conference held at the Mount Washington Hotel in Bretton Woods, New Hampshire, in
1944. This conference brought together representatives of forty-four nations in an attempt
to think through and plan out a new international financial and trade system. The new
system needed to be both stable enough to maintain confidence and able to avoid the inter-
national economic chaos of the 1920s and 1930s, and yet be flexible enough to accommo-
date changing circumstances. It is somewhat ironic that John Maynard Keynes dominated
the conference, because in most respects the two main progeny of the conference, the
IMF and the World Bank, have never demonstrated a strong affinity for Keynesian-type
approaches to economic issues. Most of the proceedings of the Bretton Woods conference
were devoted to the creation of the IMF, with the World Bank idea left semi-defined and
much in the background.2
The IMF officially came into existence in late 1945, whereupon thirty-nine countries
pledged quotas totaling $7.4 billion. According to the Articles of Agreement of the Fund,
voting power was directly related to a nation‚Ä™s quota, expressed as a percentage of the
total subscribed quotas, with each country‚Ä™s individual quota being determined jointly
by its level of economic income and population size. (The World Bank also shares this
structural characteristic.) Powerful and economically advanced nations, particularly the
United States and Britain, pledged the largest amounts to the Fund, and consequently
received a proportionately larger vote, usually enough to veto any actions that might be
proposed by the Fund which the United States and Britain strongly opposed. The majority
of the nations joining the Fund were poor and developing, and they lacked the level of
economic development and the hard currency reserves or gold necessary to create a strong
position in the IMF‚Ä™s voting structure. Fund membership has grown steadily, reaching 185
members as of September 2007 (see Figure 17.1). The IMF‚Ä™s capital stock grew to $325
billion in 2007, with slightly more than $200 billion uncommitted and available to the
In 2007, the United States continued to be the Fund‚Ä™s largest participant, holding 16.8
percent of the voting power. Yet US influence in the Fund has steadily diminished, as other
nations vie for world economic dominance. In 1982, for example, the United States held 19.6
International institutional linkages 557
1945 1955 1965 1975 1985 1995 2005
Figure 17.1 Growth in membership of the IMF.
percent of the voting power. As the United States‚Ä™ influence within the Fund has declined over
the years, so Japan‚Ä™s share (among others) has advanced. Nonetheless, the United States‚Ä™ role
is extremely important, since major changes in Fund policy can only occur when there is 85
percent of the voting power in favor of such changes. Thus, though relative US dominance
in the Fund has been reduced, the United States retains ultimate veto power over any major
decision it might wish to block.
History of the IMF
From 1946 to 1955 the Fund lent virtually nothing to its members, restricting its actions
largely to technical assistance to european member nations which were in the process of
achieving full convertibility of their currencies (see Figure 17.2). Technical assistance is
quite important as the Fund, like the Bank, exercises great influence through its consulta-
tions and advice to its member nations. During this early period, the Fund was attempting
to reach agreement in interpreting its charter and mandate, much of which was not fully
defined until 1952. Of note at this juncture was the creation of the stand-by arrange-
ment, which articulates the policies and procedures to be utilized when a nation seeks
access to the Fund‚Ä™s resources in excess of 25 percent of its quota (or first credit tranche).
Borrowing below the 25 percent limit is freely allowed without approval or condition,
since this amount represents the hard currency reserves and gold each country pays into
A nation goes to the IMF to borrow to cover a current account deficit or because of
exchange rate problems requiring foreign exchange reserves. Typically, resort to IMF
financing reflects an inability on the part of a country to access more normal channels of
international financing. In other words, going to the IMF is tacit recognition of currently
unsustainable economic policies, due either to internal policy failures or to external changes
in the international economy that adversely affect an economy ‚Ä“ such as a sudden shift in
the terms of trade or collapse of a major export commodity. In theory, the Fund‚Ä™s loans are
short term and were conceived as ‚Äúbridges‚ÄĚ for resolving short-term balance of payments
and exchange rate difficulties.
558 The Process of Economic Development
Billions of US $
1945 1955 1965 1975 1985 1995 2005
Figure 17.2 IMF lending.
a In billions of SDRs (1 SDR = 1.55 US dollars, September 2007).
Data for 2007 through September.
A ‚Äústand-by arrangement‚ÄĚ is a two-part process, whereby a member nation can draw from its
quota over a period of twelve to eighteen months.3 The first part of the stand-by arrangement
consists of a process whereby a letter of intent is signed by both the borrowing nation and the
representatives of the Fund. In order to prepare for such an agreement, a nation desiring Fund
resources must first accept the visit of an IMF delegation, which makes its own assessment
of the conditions of the borrowing nation and the macroeconomic difficulties which have led
to the need for a request for international assistance.
At this stage of negotiation, both the potential borrower and the Fund will engage in
extensive bargaining, with each side seeking to guide and control the borrowing process.
The Fund will demand ‚Äúconditions‚ÄĚ for its willingness to make a loan, thus the term condi-
tionality for such requirements, while the borrowing nation will attempt to ensure that
conditionality is as mild as possible (see Focus 17.1). How draconian the stand-by loan
conditions are depends on many factors, of which the negotiating skill of the borrowing
nation is of particular importance.4
Once a letter of intent has been signed, ‚Äúdrawing‚ÄĚ of the quota can begin. In this second
stage, the Fund reviews the progress the borrowing nation has made on meeting the agree-
ment‚Ä™s conditions every six months, with subsequent drawings dependent upon meeting
the conditions imposed. Failure to meet the conditions may, and sometimes does, result in
suspension of a stand-by arrangement. A ‚Äúdrawing‚ÄĚ from the Fund consists of a transac-
tion whereby the Fund sells ‚Äúhard‚ÄĚ currency, like the United States dollar or the euro, to
the borrowing country in exchange for its own currency, which is deposited at the Fund in
the country‚Ä™s account. To repay the loan, the borrowing country must ‚Äúbuy back‚ÄĚ its own
International institutional linkages 559
currency by using hard currencies to repurchase what it deposited, thus replenishing the
Fund‚Ä™s supply of hard currencies.5 Under a stand-by arrangement, the more a nation borrows,
the greater the scope of the conditionality and the greater the restrictiveness.
In the early years of the Fund, borrowing was never extensive. In the period 1947‚Ä“67, half of
the borrowing actually was done by the advanced nations. It was not until the late 1960s, and
particularly the early 1970s as a result of the first oil shock, that the Fund became oriented
toward lending to the developing nations. To be sure, the Fund continues to wrestle with
issues of currency stability and financial balance on a global scale ‚Ä“ its original mission ‚Ä“ but
increasingly the Fund has become an institution specializing in the problems of the devel-
oping nations. In mid-1995, the IMF had active stand-by arrangements (or similar loans, to
be discussed below) with sixty-two nations (see Figure 17.2).
During the period 1979‚Ä“93, the Fund financed 353 separate programs, suggesting that
relatively few less-developed nations were exempt from the Fund‚Ä™s direct influence in recent
years (Killick 1995: 60). The Fund appeared invigorated by its vastly expanded role, envi-
sioning much larger programs for the twenty-first century. These anticipations, however,
were steadily undermined by a wave of crises in the late 1990s. The Asian crisis (1997) and
FOCUS 17.1 WHAT IS CONDITIONALITY?
For a country to make use of IMF financial resources, it first must meet, or at least agree
to, certain macroeconomic policy conditions. These conditionality requirements range
from rather general commitments to cooperate with the IMF in setting policies to formu-
lating a specific, quantified plan for financial and fiscal policies.
Conditionality seeks to ensure that members using IMF resources will adopt the policy
measures the IMF believes are needed to improve the balance of payments positions and to
resolve their exchange rate difficulties. It is also important that the country be able to repay
the IMF in a timely manner. For ‚Äúhigh-conditionality‚ÄĚ arrangements, that is for upper credit
tranche* stand-by and extended arrangements, four conditions are generally included:
‚ÄĘ a letter of intent, which outlines the government‚Ä™s policy intentions during the program
‚ÄĘ policy changes, known as ‚Äúprior actions,‚ÄĚ that must be taken before approval of the
‚ÄĘ performance criteria, which are quantitative targets for certain policies, such as limits
on the budget deficit or on the money supply, that must be met on a quarterly or semi-
annual basis for drawings to be made and which serve as a monitoring device; and
‚ÄĘ periodic reviews during the life of the lending arrangement, another device through
which the Executive Board of the IMF assesses the consistency of policies with the
objectives of the adjustment program.
As befits the unsettled nature of Fund policies in recent years, the IMF has decided that
its policies on conditionality have often contributed to further economic turmoil. The Fund
in 2002 openly discussed the ‚Äúgrowing intrusiveness of conditionality‚ÄĚ stressing that recip-
ient countries should ‚Äúown‚ÄĚ any restructuring program. The new conditionality guidelines
mandate that the Fund will work in ‚Äúmore of a cooperative venture‚ÄĚ with borrowing nations,
reduce the number of conditions and work more closely with the World Bank on structural
changes imposed as conditions for loans. (These changes were part of a grand initiative
known as the Poverty Reduction Strategy Papers discussed later in this chapter.)
* A ‚Äútranche‚ÄĚ is a credit ‚Äúslice‚ÄĚ equal to 25 percent of a nation‚Ä™s quota, with upper
tranches being defined as borrowing above 25 percent of the quota.
Sources: IMF 1995d: 234; 2002: 390; 2007a
560 The Process of Economic Development
the Russian crisis (1998) pushed lending to new heights ‚Ä“ by 2002 lending amounted to
nearly twice the peak level achieved in 1985‚Ä“6 (Figure 17.2).
The Fund turned defensive as critiques of its policies and program abounded ‚Ä“ from the far
right of the political spectrum through the middle ranks and on to the left. The Fund‚Ä™s new
role, providing mega bail-outs with surprising frequency, raised the visibility of an institu-
tion that had long been comfortable with a very low public profile. In November 1998, for
example, the Fund pledged a $41.5 billion loan to Brazil for release in 1998 and 1999. Then,
in August 2002, the Fund approved another loan to Brazil in the amount of $30 billion. An
unprecedented 1995 mega-loan to Mexico (discussed below) had unleashed a firestorm of
criticism and commentary. The August 2002 loan to Brazil caused little notice and even less
dissent (outside Brazil).
In this new environment the Fund grappled with the stresses of a new era burdened with
the sudden and unanticipated economic breakdowns that befell some of the largest and most
important developing nations. The confidence of the early 1990s had been replaced by a
guarded wariness as the Fund sought to revise many strategies and programs. But suddenly,
in the 2002/2003 period, conditions for the Fund were once again rapidly changed: the
commodities boom, enduring through 2007, brought an avalanche of foreign exchange
to almost all developing nations. As prices for ‚Äúhard‚ÄĚ commodities such as gold, copper,
lead, oil, etc. reached record levels, and as ‚Äúsoft‚ÄĚ commodities such as soy and wheat
generally followed a strong upward trend (with some important exceptions such as coffee),
borrowing from the Fund collapsed. From a peak of 72 billion SDRs in credits and loans
outstanding in 2003 borrowing fell to only 14 billion SDRs in 2006. Lending activity was
on a par with that of the late 1970s before the debt crisis of the 1980s that had made the
Other lending facilities of the IMF
In 1963, the Fund created a new lending source, the Compensatory Financing Facility, which
would supplement resources borrowed under stand-by arrangements. This new Facility
signaled both a change in the direction of the Fund‚Ä™s concerns toward the developing nations
and the fact that the Fund would continue to reinterpret and amend its original mandate
under its Articles of Agreement. The new Facility became one of eight to be created in the
period 1963‚Ä“93, with three new lending facilities created during the turbulent years 1974‚Ä“5,
designed to increase the amounts that could be lent to borrowing nations above the original
The Compensatory Financing Facility allows member nations to borrow for the specific
purpose of coping with external shocks to export earnings and/or food imports. In effect,
the Fund acknowledged that a broad range of developing nations, which remained primary
commodity exporters to the international market, often faced sudden and uncontrollable
movements in export earnings due to the intrinsic instability of global markets for primary
commodities and their terms of trade, particularly agricultural goods.6 Such concerns also
were echoed by the creation of the Buffer Stock Facility in 1969, which was designed to
help stabilize the prices of raw materials from the cyclical volatility so characteristic of many
Further, as a result of the spike in oil prices in the early 1970s, many poor nations which
were totally bereft of petroleum resources were particularly impacted, with fuel import costs
soaring, as we saw in Chapter 16. The Fund reacted quickly by creating two other lending
sources to facilitate borrowing due to petroleum price changes: the Oil Facility and the
International institutional linkages 561
Extended Fund Facility (1974). The Extended Fund Facility allowed countries that had
used all of their regular quota drawing rights to continue to receive supplementary funding
from the Fund.
These four new Facilities were all addressed to the particular problems of the less-developed
nations and, taken together, demonstrated the new orientation of the Fund as an entity which
was primarily involved with the problems of the poorer countries. Through the 1980s and
into the 1990s, the Fund continued on this trajectory. It has created three new Structural
adjustment Facilities, which lent over a multi-year period in order to change the productive
and institutional structures of the poor nations. (Structural adjustment lending actually was
originated by, and continues at, the World Bank, as is discussed later in the chapter.) In early
1995, the Fund once again demonstrated its ability to innovate and evolve when it signed
an unprecedented $17.8 billion stand-by arrangement with Mexico, following the massive
devaluation of the peso at the end of 1994. This huge loan was 50 percent larger than all
other current stand-by loans combined, and ten times greater than Mexico‚Ä™s quota! The Fund
justified this loan as necessary to stabilize the fragile emerging financial markets of the less-
developed nations, not only in Latin America, but in Asia as well, which reacted quickly and
adversely to the Mexican peso crisis. In doing so, the IMF widened its scope of authority and
influence, once again.
Yet the deepening difficulties the Fund faced from 1997 onward forced further adapta-
tions ‚Ä“ thus in 1997 a Supplemental reserve Facility was created to deal with ‚Äúfinancial
contagion‚ÄĚ problems. Loans of this nature ‚Ä“ beginning with a $13.1 billion loan to Korea in
1997 and a $5.3 billion loan to Russia in 1998, are included in stand-by arrangements. Antici-
patory lending, a new and unusual concept, was created through the Contingent Credit
Lines program in 1999.
Breaking new ground, the IMF is now willing, in principle, to provide loans to nations
without any balance of payments or foreign reserves problems if either the nation or the
Fund felt they could anticipate a forthcoming crisis. This is an important threshold step for
the Fund, which will allow member nations to borrow up to 500 percent of their quota to
deal with a ‚Äúcontagion‚ÄĚ threat. Also in 1999 the Enhanced Structural adjustment Facility
was rechristened the Poverty reduction and Growth Facility (PRGF). Access to this fund
is restricted to ‚Äúlow income‚ÄĚ members with loans lasting up to ten years. In 2007 sixty-
three nations, many African, had PRGF approved credits ‚Ä“ the total of which was 3.9 billion
SDRs, or 35 percent of all loans outstanding (IMF 2007b).
While stand-by arrangements continue to be the primary focus of Fund lending, it is
important to recognize that increasingly the IMF has become concerned with lending for
periods well beyond the twelve- to eighteen-month focus of the typical stand-by arrange-
ment. Indeed, in the 1991‚Ä“5 period, stand-by arrangements accounted for only 45 percent
of Fund loans, while longer-term loans of up to approximately five years accounted for the
remainder of all approved loans, demonstrating the importance of the expanded lending
facilities. Table 17.1 records the IMF‚Ä™s lending activities in recent years. Note that in 2006
new loans all but evaporated, while through September 2007 the fund had lent only 1.2
While the Fund is most active with a nation when it seeks, accepts and draws a loan, the Fund
exercises its influence in other ways, notably through what is termed country surveillance.
each year, every member country must undergo an annual surveillance consultation which,
562 The Process of Economic Development
Table 17.1 New IMF loans, calendar year (billions of SDRs)a
1985 1990 1995 2000 2002 2006
4.0 4.8 18.3 26.6 2.9
Total new loans
Stand-by (+ other General Resources Account) 4.0 4.27 17.0 7.18 25.24 2.4
Structure adjustment facilities (+ PRGF funds) 0.53 1.3 0.52 1.36 0.5
Source: IMF, ‚ÄúPast Disbursements and Payments‚ÄĚ; http://www.imf.org/external/np/tre/tad/extrepl.cfm.
a One SDR = $1.55 USD in September 2007; $1.37 in March 2003; $1.28 in August 2001: $1.32 in January
according to a 1977 amendment to the Articles of Agreement of the Fund, is to include ‚Äúa
comprehensive analysis of the general economic situation and economic policy strategy of
the member‚ÄĚ (IMF 1995c: 154). Surveillance is a process which can allow the Fund to exert
leverage over economic policy-making, even when a nation is not seeking a loan from the
Fund. Of course, a country may largely sidestep the recommendations of the Fund at this
stage, but this may lead to more difficult negotiations, and more stringent limits, on any loans
which are sought from the Fund at a later date.
Objectives of the IMF
When the Fund lends to a less-developed nation, what does it hope to achieve? In the view
of the IMF, borrowing nations are largely responsible for their own economic duress. Conse-
quently, the Fund loans and intervenes so as to impose conditions which it believes will lead
to greater economic stability. Thus, except for the periods of the oil spikes of the early and
late 1970s, the Fund‚Ä™s basic position is and has been that it is fundamentally endogenous,
rather than exogenous, factors which explain the need for Fund intervention.
From the perspective of the IMF, nations are forced to make appeals to the Fund because
they have mismanaged their resources. In particular, the Fund concentrates on a nation‚Ä™s
exchange rate and its balance of payments position. Nations which seek out the Fund‚Ä™s
assistance have virtually exhausted their official hard currency reserves to finance a trade
or other current account deficit. But why do nations run a trade or current account deficit?
Largely ignoring exogenous factors such as the terms of trade, the Fund argues that troubled
nations have deliberately over-valued their currency, in effect, pricing themselves out of the
market for exports, while drawing in too many products from the international economy via
imports. Nations which are in financial trouble with unsustainable external macroeconomic
imbalances, then, are essentially living beyond their means. excess aggregate demand is the
underlying macroeconomic cause leading nations to seek loans from the Fund in this way of
looking at the situation.
To begin to solve the problem of such an imbalance, in the Fund‚Ä™s perspective, a stabili-
zation program must be introduced that typically results in compression of the economy.
excess demand and spending by consumers and government must be wrung out of the
system, and therefore a short-term economic downturn must be imposed. Once the so-called
fundamentals of the economy, that is, the key economic variables, are stabilized and brought
into equilibrium, the Fund believes that the economy will bounce back, but with a stronger