Chapter 13 Balance of Payments, Developing-Country Debt, and the Macroeconomic Stabilization Controversy Copyright © 2009 Pearson Addison-Wesley All rights reserved The Balance of Payments • The current account: net flow of merchandise trade • The capital account: net flow of financial capital Copyright © 2009 Pearson AddisonWesley All rights reserved 13-2 The Balance of Payments The current account: • Exports (+) • Imports (-) • Investment income (+) • Debt-service payments (-) • Net remittances and transfers (+) Copyright © 2009 Pearson AddisonWesley All rights reserved 13-3 The Balance of Payments The capital account: • Direct private investment (+) • Foreign loans (+) • Foreign assets of domestic banks (-) • Resident capital outflow (-) Copyright © 2009 Pearson AddisonWesley All rights reserved 13-4 Copyright © 2009 Pearson AddisonWesley All rights reserved 13-5 Copyright © 2009 Pearson AddisonWesley All rights reserved 13-6 The Balance of Payments • • The balance of payments position: – Surplus: inflows > outflows – Deficit: outflows > inflows Consequence: – Surplus: increase in cash reserves account – Deficit: decrease in cash reserves account Copyright © 2009 Pearson AddisonWesley All rights reserved 13-7 Payments Balances on Current Account, 1980–2006 (billions of dollars) Copyright © 2009 Pearson AddisonWesley All rights reserved 13-8 Consequences of BOP Deficit • Reduce cash reserves account • Inhabit imports: impose tariffs/quotas; foreign exchange devaluation • Increase exports: foreign exchange devaluation Copyright © 2009 Pearson AddisonWesley All rights reserved 13-9 Consequences of BOP Deficit • Impose restrictive fiscal and monetary policy – Reduce income expansion to lower import growth – Reduce inflation for exports to compete internationally • Attract direct foreign investment • Receive a greater share of the IMF’s “paper gold” known as the Special Drawing Rights (SDRs) • Increase external debt Copyright © 2009 Pearson AddisonWesley All rights reserved 13-10 Third World Debt Crisis • The accumulation of external debt Since early 1980s • Allocation of a larger percentage of the GDP (from export earnings) to service external debt • Scarcity of development funds: lack of investment in physical, human, and social capital Copyright © 2009 Pearson AddisonWesley All rights reserved 13-11 Dimensions of the LDC Debt Burden, 1970–2008 Copyright © 2009 Pearson AddisonWesley All rights reserved 13-12 Severely Indebted Countries • Large outstanding debt • Debt as a large percentage of GDP and exports • High debt service-to-GDP (or GNI) ratio • High debt service-to-exports ratio Copyright © 2009 Pearson AddisonWesley All rights reserved 13-13 Copyright © 2009 Pearson AddisonWesley All rights reserved 13-14 External Debt Accumulation Define Fn as the capital inflow (i.e., the amount of debt accumulation) Fn = dD D = total external debt d = percentage increase in total external debt Copyright © 2009 Pearson AddisonWesley All rights reserved 13-15 External Debt Accumulation • Define BT as the basic transfer and r as average interest rate charged on external debt BT = dD – rD = (d - r)D - dD: external debt - rD: amortized debt - d>r: debt accumulation Copyright © 2009 Pearson AddisonWesley All rights reserved 13-16 The Debt Crisis • Rising d and d > r • Switching from fixed, concessional rates to short-term, variable rates • BOP deficits as LDCs’ commodity prices plummeted Copyright © 2009 Pearson AddisonWesley All rights reserved 13-17 The Debt Crisis • Global recession, reducing demand for LDC exports • Lack of confidence in LDCs’ ability to repay foreign loans • Substantial amount of capital flight from the LDCs Copyright © 2009 Pearson AddisonWesley All rights reserved 13-18 Petrodollars and Third World Debt The OPEC (i.e., Qatar, Saudi Arabia, Kuwait): • Exports oil to LDCs and MDCs • Deposits some of their export earnings in Western banks • Provides grants and interest-free loans to LDCs Western Banks: • Lend petrodollars to LDCs • Receive debt service payments from LDCs Copyright © 2009 Pearson AddisonWesley All rights reserved 13-19 The Mechanics of Petrodollar Recycling Copyright © 2009 Pearson AddisonWesley All rights reserved 13-20 The IMF Stabilization Policy • Remove foreign exchange and import controls • Use a floating foreign exchange rate • Adopt stringent anti-inflationary policy – Increase interest rates – Reduce budget deficits – Control wage increases – Eliminate price subsidies • Invite foreign investment and improve economic openness Copyright © 2009 Pearson AddisonWesley All rights reserved 13-21 The IMF Stabilization Policy Success in LDCs: • Reduce inflation • Improve balance of payments • Eliminate parallel exchange rates • Improve economic efficiency Copyright © 2009 Pearson AddisonWesley All rights reserved 13-22 The IMF Stabilization Policy Failure in LDCs: • Double standards – Harsh adjustments for the LDCs – No adjustment for the MDCs • Lending agencies – Agents of international capitalism – Increase LDC dependence and poverty – Prefer short-term to long-term developmental loans – Provide Copyright © 2009 Pearson Addisonfunds for corrupt LDC governments Wesley All rights reserved 13-23 Global Dimensions of LDC Debt • Restructuring of short-term to long-term loans • Debt forgiveness to selected LDCs if they continue to use IMF stabilization policy • Debt-for-equity swap: banks exchange loans for ownership of domestic industries • Debt-for-nature swap: MDC government forgive loans if LDCs invest in preserving the environment Copyright © 2009 Pearson AddisonWesley All rights reserved 13-24 Has the Debt Crisis Disappeared? No! Debt crisis is just postponed! • LDCs continue to borrow • LDCs continue to make large debt service payments • In addition to the severely indebted LDCs, countries in Africa are greatly dependent on external debt Copyright © 2009 Pearson AddisonWesley All rights reserved 13-25 ... AddisonWesley All rights reserved 13- 4 Copyright © 2009 Pearson AddisonWesley All rights reserved 13- 5 Copyright © 2009 Pearson AddisonWesley All rights reserved 13- 6 The Balance of Payments • •... service payments from LDCs Copyright © 2009 Pearson AddisonWesley All rights reserved 13- 19 The Mechanics of Petrodollar Recycling Copyright © 2009 Pearson AddisonWesley All rights reserved 13- 20... service-to-exports ratio Copyright © 2009 Pearson AddisonWesley All rights reserved 13- 13 Copyright © 2009 Pearson AddisonWesley All rights reserved 13- 14 External Debt Accumulation Define Fn as the capital