Since the early 1980s, the international financial community has been uncertain about how to provide debtor countries with the financing they need for adequate growth. Can and should private capital flows meet the demand? To what extent can official assistance replace private financing?
Some economists argue that if perfect markets prevailed throughout the world, private capital would naturally flow from the capital-rich North to the capital-poor South, equating at the margin the cost of funds in the North with the risk-adjusted rate of return in the South. But markets are not perfect. Besides, political risks in certain countries and long-term prospects for returns from certain infrastructural investments discourage commercial lending to support potentially profitable investments. This is a major argument for official development assistance (ODA) and other types of official financing.
In this analysis, ODA is treated as supplementing private capital flows. But the converse notion-that private capital flows supplement ODA-was voiced in the 1970s, when ODA was not growing rapidly enough to meet the demands of developing countries for financial assistance. Even today, when there is little or no recourse to private capital markets for many potential borrowers in the South, the same argument is offered to support the urgent establishment of economic conditions that would permit restoration of “normal” creditor-debtor relationships.
Private capital. Private capital, mainly bank loans and bond purchases, was the principal source of external finance to developing countries from the early 1970s until recently. Private lending peaked in 1981 at $90 billion (see table), declined sharply during 1982-83, and has continued downward ever since. Determinants of the supply of private finance are various and complex. The supply of bank financing seems to be mainly affected by economic growth in creditor countries and therefore in banks’ total portfolios, and by economic performance in debtor countries, which influences the share of those countries’ liabilities in banks’ portfolios.
The cost to developing countries of bank loans is determined principally by the rate of interest in world financial markets. While spreads over the most commonly used index, the London Interbank Offered Rate (LIBOR) vary, such variations may not fully equalize the demand for and supply of funds to a country. While the prevailing interest rate is determined mainly by economic conditions in creditor countries, rates of return on investment in a debtor country do influence the supply of bank lending to that country. This influence is brought to bear on the banks’ perception of the default risk and their desire to maintain a presence in the debtor country’s economy, both of which affect the spreads on loans and banks’ portfolio decisions. The risk element, which has dominated the reduction of lending in the 1980s, is, in turn, influenced by the debt-service burden and capacity of the borrowing country, its political stability, the effectiveness of its economic policies, and its prospects for export expansion and overall economic growth. The expected return on bank lending incorporates these risk elements.
Another influence on the external debt situation of developing countries has been the flow of deposits from these countries into the major financial centers; for two decades these centers have functioned increasingly as financial intermediaries for countries whose own financial systems have suffered from financial repression. The outflow of residents’ saving to the major financial centers has starved domestic financial institutions of funds, leading to increased borrowing from external financial centers. This situation has been compounded in many instances by large fiscal deficits “crowding out” credit to the private sector.
This article is based on a longer paper presented at a conference on North-South cooperation sponsored by the Netherlands Ministry of Development Cooperation. The paper will be published in a forthcoming volume by Croom Helm Ltd. (Beckenham, U K).
Although in normal times it is good business for banks to lend to their own depositors, whether domestic or external, banks have nonetheless become reluctant to lend new money to depositors in countries with a debt-servicing problem. Regulators in some creditor countries have reinforced this reluctance by requiring banks to strengthen capital/asset ratios and to increase provisioning against risky loans. Meanwhile, however, they have continued to encourage concerted lending in specific cases.
|Current account deficit||18.6||46.3||76.3||116.8||107.6||65.0||38.1||41.3||43.2|
|Use of reserves||1.5||-2.0||-22.9||0.4||17.5||-9.9||-20.0||-10.7||-14.0|
|Errors and omissions||0.1||-7.2||-16.1||-18.9||-25.3||-9.9||-2.2||-5.4||-2.1|
|Use of Fund credit||-0.5||2.1||1.4||6.1||6.7||11.2||4.9||0.3||-2.2|
For the immediate future, the amount and terms of commercial bank lending will depend in part on the types of lending instruments available. New lending might be encouraged by a secondary market for loan sales and swaps, which has already begun to develop. Other new financing arrangements include debt-equity conversions, long-term floating rate notes, use of cash reserve funds or zero-coupon hard currency bonds as collateral, and bank lending for export-oriented projects whose earnings could be earmarked for debt service.
Certain other innovations have, for the most part, only reached the discussion stage, although a few pilot arrangements are under way. These include investment by nonbank financial institutions in equity in developing countries, investment by multinationals or bank consortia in projects on the basis of shares of revenue or profit, and index-linked or commodity-linked bonds.
Some of the new arrangements highlight the possible substitutability between bank lending and foreign direct investment-that is, between debt and equity financing. The supply of foreign direct investment depends on economic growth in the host country, its political stability and macroeconomic policy environment, its location and export potential, and the institutional and policy features that either encourage or restrict foreign participation in domestic enterprises. In recent years more than half of new net foreign direct investment has gone to no more than three or four countries, and the existing stock of foreign direct investment is concentrated in a relatively small number of host countries. While these groups include some of the large and medium-sized developing countries, they exclude several large economies, such as China, India, and the Republic of Korea, that traditionally have limited large-scale foreign direct investment.
Official financing. The term “official financing” comprises concessional official development assistance and nonconcessional official development flows. The latter include officially guaranteed export credits and World Bank loans. ODA is directed largely to low-income countries; official development flows, to middle-income countries. (The use of Fund resources is not counted as development finance, but the extended Fund facility and Structural Adjustment Facility provide finance with maturities of up to ten years in support of growth-promoting adjustment policies.)
To the extent that ODA is simply motivated by the desire to support economic development efforts, there is, in principle, a link between the amount of aid offered particular countries and the social return to the corresponding investment. While the use of ODA is justified on the grounds that social return is larger than the private rate of return when the latter is too low to justify market borrowing, social return itself depends on many of the same factors that influence expected private profitability. A deterioration, for example, in growth prospects may weaken political support in donor countries for continued aid.
The flow of ODA is not determined solely by rates of return. Fiscal constraints and priorities in donor countries also influence the volume of official financing. Strategic political and military considerations often have played dominant roles in determining the direction of bilateral aid flows, as have humanitarian concerns and linkages between aid and promotion of the donor’s exports. With respect to export promotion, a notable recent tendency is to combine export credits at commercially related terms with highly concessional assistance.
Substitutability and complementarity: a creditor’s view. In the 1980s, private capital has not filled the gap between the financing needs of developing countries and the amount of official financing available. The volatile changes in bank lending have not been synchronized with the demand for external financing. Foreign direct investment and bonds have proved somewhat more stable, although as noted earlier, they have been available in substantial volume only to a rather small number of countries.
The view that ODA and official development flows should be regarded as a substitute for private financing has received some validation over the past several years during which official financing, to some extent, provided a safety net for debtor countries as private lending diminished. In the long run, however, the budgetary stringency that most donor countries face is likely to severely limit this process.
Private capital and official financing have commonly been considered complementary in the sense that private capital is best suited to financing foreign trade and projects with a relatively short gestation period as well as projects whose expected returns are commensurate with commercial rates of interest, while official financing is best suited for long-gestating(e.g., infrastructural) projects. For the private creditor, the latter projects carry the risk that the debtor might not be able to service medium-term debt on schedule, while concessional assistance used to finance commercially viable projects remains open to the criticism that it provides an unwarranted subsidy to activities that could have been privately financed at commercial terms.
Demand for external finance
Borrowing countries face basically two problems in attracting foreign capital. First, a large and positive net payment for factor services, such as interest payments to nonresidents, can “crowd out” imports and force a cutback in either investment or consumption. Second, net capital outflows increase the amount of foreign financing necessary to sustain desired investment. To the extent that increases in foreign borrowing are used merely to service earlier debt, the cost of such financing at the prevailing interest rate will be greater than the marginal social rate of return on additional investment being financed. There may be other social returns, such as the short-run benefits of averting politically difficult adjustment measures, but the result is a more severe debt-servicing problem in the future.
The demand for financing is also related to its cost. One would expect the demand for external financing to increase with a falling interest rate, reflecting a growing positive difference between private saving and investment. For heavily indebted borrowers, however, this effect may be more than offset by the need to obtain additional financing to cover higher debt-service payments when interest rates rise.
Considerations of debt management may also strongly influence and sometimes govern official demand for external finance. Unlike the private borrower, who is motivated solely by his own cost and the return he realizes from using borrowed funds, the official borrower must reckon with the macroeconomic effects of the overall increase in external indebtedness-including the indebtedness of private residents. When an economy’s aggregate debt-service burden has risen rapidly, the government may decide to limit the further growth of external debt. It may do so by trimming public sector expenditures or by raising taxes; by taking steps to encourage private saving or to curtail private investment; by imposing direct limits on the private and public sectors on further borrowing abroad; and by attempting to reduce debt-service payments through agreements with creditors or unilaterally. Finally, in order to produce an outcome on the external side corresponding to the desired levels of domestic saving and investment, the government may have to take measures, such as exchange rate adjustments, to reduce imports and expand exports. Alternatively, in order to avoid the need to carry out such measures while at the same time maintaining debtservice payments, the government may decide to seek additional financing.
The demand for external finance may be influenced by the longer-term prospects of availability of such finance. For instance, a sharp increase in the availability of external finance or a fall in its cost would create an excess supply, inducing governments to reassess their need to finance government investments and/or fiscal deficits.
Substitutability and complementarity: a debtor’s view. External finance is to some degree fungible between the private and public sectors. For example, certain types of ODA may directly finance private sector activities; loans guaranteed by the debtor country government may be channeled directly to private borrowers (for example, export credits or sector loans of the World Bank); and some official borrowing may be on-lent to private borrowers. Moreover, additional ODA directed to the public sector frees domestic saving for financing private investment.
Nevertheless, a cutback in external finance will generally have different effects on the public and private sectors. When foreign commercial banks reduce their lending, the private sector may be affected more unfavorably than the public sector if the private sector has depended on foreign financial intermediation for much of its trade and investment credit, domestic residents continue to place saving abroad, and official lending covers a large part of the public sector’s financing requirements.
Long-standing government policies affect the composition, and hence the substitutability, between different forms of external financing. Many countries limit foreign direct investment, often to avert foreign control of productive activities. Some governments have, at times, prohibited external commercial borrowing by the public sector and strictly controlled such borrowing by the private sector, because they considered the terms of the loans inappropriate for investment in a developing country, and because of fears that future debt-servicing requirements would limit the use of foreign exchange for essential purposes.
Official borrowers naturally prefer concessional ODA to other forms of external resources because of its concessional terms. A negative feature of some ODA, however, is that a large part of it is tied either to particular projects or to imports from the donor country. Certain types of relatively quick-disbursing and untied loans, notably World Bank structural adjustment and sectoral loans, are associated with policy conditions and nonconcessional terms.
In the 1970s, borrowing from private sources was attractive because it was quick-disbursing and nonconditional and because, until 1979, real interest rates were low, even negative. Nevertheless, such borrowing by governments often created serious problems. Although the heavy borrowing of the 1970s and early 1980s enabled developing economies to invest a larger proportion of their GDPs than might otherwise have been the case, much of it was used for consumption or to finance capital outflows. Furthermore, the returns on the additional investment did not necessarily accrue to the government or other public sector borrowers. Moreover, the terms and maturity of private financing do not always correspond to the timing of returns on the investment. In the case of infrastructural investment, long-run returns depend also on the ability of the government to meet the recurrent costs involved in maintaining the investment after its completion. For all these reasons, the authorities’ ability to service the resulting external debt has necessitated raising additional revenue. Because tax revenues in developing countries are often inelastic with respect to output, tax rates have frequently had to be raised or new taxes introduced. An additional complication in many countries has been that inappropriate economic policies have led to inadequate growth of the capacity to generate the foreign exchange required for debt service.
A number of governments in heavily indebted countries have recently been more favorably inclined to nondebt-creating private capital flows and have limited borrowing from foreign commercial banks. While the latter tendency to some extent reflects simply limited availability of bank financing, there have been initiatives by governments to ease limitations on foreign direct investment and to carry out more rigorous adjustment policies to avoid a further worsening of their external position.
Both the Fund and Bank’s policy conditionality and the management of ODA by donor country aid agencies involve requirements by lenders or donors that the resources be used in ways that meet certain purposes: improved financial stability and international competitiveness, which are especially emphasized in programs supported by the Fund and Bank; and productive investment and fulfillment of basic needs in the case of ODA (including, of course, financing from the Bank). These purposes are overlapping and complementary. A successful Fund-supported program or Bank structural adjustment loan should improve the overall macroeconomic environment and efficiency of resource allocation. Such improvements, in turn, should serve to raise returns on both official and private investment, including projects currently supported by ODA, as well as stimulate a greater inflow of foreign private resources.
Nevertheless, Fund-supported programs in particular have been criticized for having the effect of cutting back on development programs, because the fiscal adjustments required under stand-by arrangements usually have fallen heavily on government investment expenditure. To be sure, under programs supported by the Bank and Fund, painful choices have had to be made in reducing government expenditure. There has sometimes been considerable scope for cutting wasteful public investment projects. Harder choices must often be made among current expenditures. Some of these--such as in education, health, and maintenance of energy and transport infrastructure--are as crucial as is investment to sustaining and expanding output. But others, such as salaries and defense, are politically sensitive. Cutbacks in local outlays on investment and capital maintenance expenditures have naturally influenced the volume and direction of official financing.
The lack of coordination of official financing originating from many different donor countries and institutions and the resulting lack of complementarity among individual loans or grants have long been obstacles to the efficient use of such assistance. (See “Aid coordination: a recipient’s perspective” by Sven B. Kjellstrom and Ayite-Fily d’Almeida, Finance and Development, September 1986.) To be sure, the consultative groups of donors organized by the Bank have played a useful role. But because official financing generally complements the recipient countries’ own resources, coordination also needs to come from within the recipient country, and this might best be accomplished by strengthening the Ministry responsible for coordinating external assistance. Of course, for some low-income countries, this will require a considerable degree of institution building, which by its very nature requires technical assistance from the outside.
The closer collaboration in recent years between the Bank and the Fund has strengthened aid coordination and its linkages with Fund-supported programs. The Bank and Fund jointly prepare economic policy framework papers in connection with the Fund’s Structural Adjustment Facility. These papers are intended to help mobilize additional ODA and to coordinate ODA management. Although additional ODA is still at the discussion stage, aid agencies have expressed interest in using the policy papers as general guidelines for aid efforts.
With the possible exception of Japan, it seems likely that the fiscal stance of donor countries will, in the immediate future, limit the growth of official financing in real terms. Prospects for increasing resources available to the Fund and World Bank are mixed. Meanwhile, overall nontrade-related lending by commercial banks has dipped, despite larger flows to a small number of countries with strong economic prospects.
The ability of donor country governments to encourage, where appropriate, expanded private sector lending through official guarantees, banking regulation, and other devices is considerable. New financing of these types will not be forthcoming, however, unless warranted by adequate expected returns, which in turn will require a strong economic performance in debtor countries. Needless to say, such performance depends in considerable part on the growth and openness of foreign markets. Nevertheless, chronic policy failures and slow growth of donor countries have contributed to foreign banks’ reducing new financing for many debtor countries and the weakening of political support for ODA and multilateral development banks. Conversely, strong recipient government policies, high levels of domestic saving and investment, and efficient use of domestic resources will attract external resources.
Appropriate policies may not be sufficient, however, in countries where existing debt, even if restructured, cannot be serviced without severely impeding future economic growth. Strengthening economic performance for countries with an excess demand for financing may require initial increases in financial assistance. Assuming such financing becomes available, the chief task will be to create an environment in which both public and private sectors use resources more efficiently. This is especially relevant to low-income countries, where political will and heavy doses of technical assistance are required, and where additional financing will need to be largely concessional.
The complementarity of official and private sources is heightened in these circumstances. Because the overall economic performance of a debtor country is so important for calculating expected returns to investment, private investors need the assurance that official donors, especially the Fund and World Bank, are offering advice and monitoring policies of the debtor countries.
FINANCE & DEVELOPMENTis available on microfilm from university Microfilms, P.O. Box 1346, Ann Arbor, Ml 48106, USA, and on microfiche (English only) from Microphoto Division, Bell and Howell Company, old Mansfield Road, Wooster, OH 44691, USA