Information about Asia and the Pacific Asia y el Pacífico

4 The Role of Aid and Private Capital Inflows in Economic Development

Frank Holmes
Published Date:
January 1987
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Information about Asia and the Pacific Asia y el Pacífico
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I. Introduction

The role of foreign capital in economic development has been a subject of international debate for as long as development itself has existed. In the 1950s and 1960s the discussion centered on aid flows, direct foreign investment, and export credits. Since the mid-1970s attention has shifted to private banking flows and developing country debt problems.

In absolute terms the developing countries’ capital needs, say to the year 2000, are enormous. Achieving even moderate living standards in the poorer and more populous countries, notably India and China, will require very large absolute capital amounts. But, year by year, in relation to the developing countries’ savings and absorptive capacities for investment, their capital needs are both measurable and manageable.

Except for very small countries, the contribution that foreign capital can make to development can only be marginal; but it is, of course, at the margin that capital inputs matter, particularly in association with the technical inputs that aid and private capital bring. The policy issues of concern to developing countries are centered on the quality of the technological and management components of the capital inflow “package,” the optimal levels of flows, the real economic as well as financial costs of flows, and the benefits arising from the uses to which the imported capital is applied. But in small countries, and in large doses even in medium-sized countries, aid can have “Dutch Disease” effects that are difficult to neutralize. Private capital flows that are large in relation to an economy can also undermine rather than strengthen economic performance. Excessive foreign capital flows have proved costlier to development than insufficient ones.

The volume of capital flows to any developing country is largely demand-determined. All developing (and East European) countries still account for less than 10 percent of total world borrowing. Their solvency and liquidity are of concern to international capital markets because lending is highly concentrated in some 30 banks and a dozen or so debtor countries that have borrowed excessively. Unfortunately, there is no developing countrywide solution to such excessive lending and borrowing. Each excessive lender and borrower must set its own house in order. The schemes put forward to help developing countries overcome their indebtedness and to safeguard international capital markets would be likely to lead to more problems than they remedy, because they would add new “moral hazards” to those already created by the guarantees, subsidies, and other distortions that have contributed to excessive borrowing and lending in the past.

The range of development experience since 1945 has been very broad. In some countries living standards of the majority of the population have changed little. In a few they have even deteriorated. But in other countries, including some that were very poor at the end of World War II, living standards are rising appreciably, and a few countries are catching up with and bypassing the more slowly growing industrial countries.

There are many hypotheses as to why some countries have grown faster (and at the same time more equitably) than others (Riedel (1986)). But three old verities about the relationship of capital to growth have stood the test of time. First, the investment of capital is necessary, but not sufficient, for growth. Second, the degree to which investment stimulates growth depends on the efficiency with which it is used, and such efficiency is determined by a country’s own policies. Third, capital tends to flow from higher-income (industrial and small population, natural resource-rich) countries, where capital is relatively plentiful and has a low marginal productivity, to lower-income countries, where capital is relatively scarce and has a high marginal productivity.

All countries face the same international conditions. These conditions affect their ability to raise their productivity and competitiveness through trade, and hence their capacity to absorb aid and to borrow abroad. Supply conditions in national and world markets are, of course, also important in the determination of capital inflows, but developing countries are still marginal users of the capital that flows internationally. The extent to which a country saves, invests, and obtains capital abroad, and whether or not it does so optimally, depends principally on its domestic policy framework. That is, the mix, interconnections, and consistencies of a country’s financial, monetary, trade, fiscal (and public ownership), exchange rate, manpower, and other policies determine the level of capital inflows and their impact on growth.

The next section of this paper reviews the relationship between foreign capital inflows and development. Section III presents a stylized model of capital flows to developing countries. Section IV concludes with a consideration of the relationship of debt to development.

II. Foreign Capital and Development

Although the Harrod-Domar model placed (physical) capital investment firmly at the center of development economics, the intellectual foundations of the role of foreign capital in development were only developed in the mid-1960s, largely through the work of Hollis Chenery for the U.S. Agency for International Development (AID). The two-gap model (Chenery and Strout (1966)) held center stage for a decade and more: in crude terms it was argued that developing countries in the early stages of development could neither save enough nor import enough capital goods from abroad to satisfy their investment requirements. Aid flows were needed to bridge these two gaps, mainly in the form of concessional loans. This philosophy suited Robert McNamara’s drive to expand the activities and influence of the World Bank, particularly during the early and mid-years of his presidency. With soaring global liquidity after 1974 increasing the global supply of capital while the demand for capital faltered in industrial countries, the two-gap theory of development was extended to apply to private capital flows as well as to aid, intellectually underwriting the expansion of private as well as official capital flows to developing countries.

There was no dearth of critics of the two-gap theory, but their analysis was muted lest they be thought to be opposed to aid. However, at the end of the 1960s three types of empirical evidence cast serious doubt on the two-gap theory. Savings rates were clearly not a function of a country’s “poverty” (as measured by per capita income), but of economic policies and administrative capability. Countries could—and some did—overcome their balance of payments difficulties by “unshackling” exports (Riedel (1986)). There was clearly no fixed relationship between imports and growth. Marginal import to growth ratios were often twice as high in Latin America as in East Asian countries. Capital inflows did not necessarily lead to growth. Economies such as the Republic of Korea and Taiwan Province of China did not grow rapidly in periods of high aid inflows. Arguments that such aid created preconditions for growth were weak. At best, there was some contribution to the building of a human and physical infrastructure. Capital inflows were often inversely correlated with growth. The poorest, least developed and least development-oriented countries attracted the most aid. Banks proved unable to “pick the winners” among developing countries. Although some countries, notably in East Asia, borrowed well for growth, their experience was swamped by the major borrowers that did not have appropriate domestic policies for borrowing.

The increasing weight placed on human capital is an important factor in explaining the failure of foreign capital inflows to lead to growth. Foreign expertise cannot substitute for local skills, notably in policy formulation and administration, both of which are essential to prudent borrowing and the productive use of borrowed funds. Ideology and political insecurity can exacerbate the lack of human capital, leading to relatively low savings and investment rates and higher incremental capital output ratios than per capita income levels alone would imply.

Capital inflows, particularly of aid funds, can create economic rent effects similar to those of the Dutch Disease (Corden (1984)). Public administration can become the “booming” sector. It can be argued that such effects are even more virulent than those of mineral rents because, instead of percolating from goods to services, they immediately swell government employment. Resources are drawn to government where they receive excessive remuneration; the private sector is correspondingly denied human and physical capital and is burdened by high wages and other costs. With high capital inflows, the rate of exchange becomes overvalued in relation to domestic costs. With high aid to national income ratios, which are typical of small, poor countries, aid flows can become counterproductive if they are not offset by appropriate national policies. This is the case in some low-income sub-Saharan African and small island countries. Foreign capital inflows in “low income sub-Saharan Africa,” for example, represent nearly two thirds of the low investment that takes place (Table 1).

Table 1.Gross Domestic Investment in Gross Domestic Product and Net Capital Inflows in Gross Domestic Investment, 1970–80(In percent)
Gross Domestic

Investment as a

Share of Gross

Domestic Product
Net Capital

Inflows as a

Share of Gross

Domestic Investment
Low-income countries1
Africa, south of Sahara15.615.528.762.9
Middle-income countries1
Oil importers23.525.914.917.5
Oil exporters20.529.713.310.8
All developing countries22.927.210.713.5
Sources: World Bank (1983), and Poats and Organization for Economic Cooperation and Development (1985).

For definition of country groups, see World Bank (1985a).

Sources: World Bank (1983), and Poats and Organization for Economic Cooperation and Development (1985).

For definition of country groups, see World Bank (1985a).

Private capital inflows can also have associated Dutch Disease costs. If policies lead to a misallocation of resources among sectors, for example, biasing investment toward protected manufacturing industries, capital inflows can exaggerate the high costs of inappropriate policies. Where private capital inflows are used to bolster government budgets so that fiscal reform can be avoided, the effects are also counterproductive.

In a well-run economy, where capital inflows are marginal, their stimulus to growth can be substantial, particularly if they carry substantial human capital and technical inputs that are otherwise difficult to obtain. The technology-management package that accompanies private direct foreign investment is well known for its positive values, but aid and banking flows can have similar effects.

In contrast, the rents associated with capital inflows cannot be laundered out of a national economic system by being invested abroad. The only effective way in which the Dutch Disease associated with high capital inflows can be avoided is through policy reform, but this is often difficult to implement. Political realities then indicate that conditions have to be laid down by donors or lenders if negative Dutch Disease effects are to be avoided.

Where essential policy changes are difficult to achieve for political reasons, bureaucrats and politicians can often use “conditionality” as a scapegoat. But the technical components of capital inflows and conditionality are not always appropriate. Suppliers’ credits, for example, can have very distorting effects, despite low costs. Policy conditions imposed by donors may be wrong. A country must give itself the room, by its long-term policies, to be able to do without foreign capital if it judges the conditions that accompany it to be unwise. However, for well-run developing countries, foreign capital, at the margin, can contribute markedly to growth by adding to capital, technological, and management resources at an affordable cost.

III. Evolution of Capital Flows to Developing Countries

Aid, private direct foreign investment packages (with entrepreneurial and technical components), export credits, syndicated bank loans, and other forms of capital flows form a continuum of complementary and substitutable international capital transfer instruments. The essential homogeneity of capital makes it very difficult to distinguish among the various flows. Borrowers and lenders move among the capital instruments available to them in response to relative prices (including such nonmonetary aspects as conditionality and risk). The prices of capital, in turn, reflect the demand and supply schedules of the borrowers and lenders (Hughes (1979, 1984)).

In stylized form, the evolution of capital flows in developing countries may be described as follows. A low-income developing country initially has two main sources of external finance: trade credit and official flows. The latter includes technical assistance, aid in kind, grants, the concessional component of bilateral loans, official export credits, military aid, and the concessional component of multilateral drawings and loans. Some aid flows, such as concessional loans, have a monetary cost, and almost all aid is conditional and hence has costs in some sense (Ohlin (1966) and Wall (1973)).

As a country develops, official inflows continue, and more private capital generally becomes available (Hope and McMurray (1984)). Even relatively undeveloped countries can attract some private direct foreign investment, notably in natural resources (mining, timber, plantation agriculture), in the processing of natural resources, in manufacturing (for the domestic market and for export), and in service industries. Export credits, too, usually become available at very early stages of development for both private and public investment. But because export credits are frequently subsidized by the lender’s government, they often lead to excessive borrowing and debt difficulties. A country can therefore acquire relatively high capital servicing liabilities in relation to both its gross domestic product and its exports at an early stage of development.

In later stages, a country’s private and public borrowers are regarded as “creditworthy” for bank borrowing and ultimately for bond issues, though the latter have been little used, in contrast to the nineteenth century. The country can then shift from direct investment and export credits to bank sources, thereby avoiding drawbacks that may be associated with foreign investment and supplier’s credits. Countries generally continue to take some advantage of the direct investment “package,” and they may still find export credits attractive, but they no longer have to depend heavily upon these sources. Thus far, developing country access to bond markets has been largely indirect, channeled through the multilateral banks. Some countries, however, have successfully launched bond issues, principally to prove their creditworthiness to banks. By this stage of development, official flows, even from multilateral banks, are usually declining.

Because of domestic policy distortions, political ties and fluctuations in capital markets, the evolution of capital inflows has not always followed this stylized pattern. During periods of high international liquidity, some countries still in very early stages of development have obtained bank loans, notably to replace equity in natural resource development. On the other hand, some relatively high-income countries have chosen not to borrow a great deal from private sources.

Official sources dominated capital flows to developing countries in the 1950s and early 1960s, when many developing countries were gaining independence and more industrial countries became interested in assisting development. Both official and private flows continued to grow in the 1970s (Tables 2 and 3). The industrial countries increased the concessionality of their aid at the same time as they were increasing its volume. Net aid from members of the Organization of Petroleum Exporting Countries (OPEC) rose rapidly in the 1970s to a peak of about $8 billion in 1980. Total aid flows thus also peaked in the early 1980s, although industrial countries have continued to maintain and even increase aid flows, particularly in recent years. But net private flows rose even faster from about $8 billion in 1950–55 to nearly $70 billion in 1981 as countries attained creditworthiness in highly liquid markets. Thus, even in real terms the increases in total capital flows to developing countries have been impressive.

Table 2.Total Resource Flows to Developing Countries by Type, 1950–84(In billions of U.S. dollars at 1983 prices and exchange rate)
Official development assistance(8.35)19.5422.1836.0536.2333.6933.8035.75
Flows from bilateral sources8.3518.6019.3828.7528.5226.2126.2327.35
DAC countries18.3515.8714.8216.9917.7118.3518.5320.10
OPEC countries21.028.197.464.564.333.79
CMEA countries31.802.602.482.882.862.942.95
LDC donors50.910.930.
Flows from multilateral agencies0.942.807.307.717.487.578.40
Grants by private voluntary agencies2.252.171.972.302.342.50
Nonconcessional flows7.5415.2928.6655.6668.5660.1082.1254.00
Official or officially supported6.5710.3622.9121.5521.9019.8220.00
Private export credits (DAC)2.035.4710.4310.997.065.505.00
Official export credits (DAC)2.801.542.311.952.652.102.50
Other official and private flows (DAC)0.940.650.681.912.623.003.003.00
Other donors0.843.521.132.992.002.00
Direct investment6.549.669.8916.7711.817.809.50
Bank sector62.187.8521.5729.1925.8954.0024.00
Bond lending0.791.291.050.510.500.50
Total resource flows(15.89)34.8353.0993.88106.7696.09118.2692.25
Total bank lending
of which:45.9650.5940.8335.0018.00
Short term24.3921.4014.94–19.00–6.00
IMF purchases, net70.892.456.016.3812.485.50
Source: Poats and Organization for Economic Cooperation and Development (1985).

Development Assistance Committee.

Organization of Petroleum Exporting Countries.

Council for Mutual Economic Assistance.

Non-Development Assistance Committee/Organization for Economic Cooperation and Development.

Less-developed country.

Bank sector includes, for 1983 and 1984, significant amounts of rescheduled short-term debt. The real evolution of bank lending is best reflected in the line showing “Total Bank Lending” at the bottom of the table.

International Monetary Fund.

Source: Poats and Organization for Economic Cooperation and Development (1985).

Development Assistance Committee.

Organization of Petroleum Exporting Countries.

Council for Mutual Economic Assistance.

Non-Development Assistance Committee/Organization for Economic Cooperation and Development.

Less-developed country.

Bank sector includes, for 1983 and 1984, significant amounts of rescheduled short-term debt. The real evolution of bank lending is best reflected in the line showing “Total Bank Lending” at the bottom of the table.

International Monetary Fund.

Table 3.Resource Flows to Developing Countries, 1950–84(Percentage shares of total flows)
Official development assistance(52.5)55.941.838.433.935.135.941.9
Flows from bilateral sources52.553.636.530.626.727.327.832.0
DAC countries152.547.727.918.116.619.119.723.6
OPEC countries21.
CMEA countries34.
LDC donors52.
Flows from multilateral agencies2.
Grants by private voluntary agencies4.
Nonconcessional flows47.544.154.059.364.262.561.655.2
Official or officially supported18.919.524.420.222.821.023.5
Private export credits (DAC)5.910.311.
Official export credits (DAC)
Other official and private flows (DAC)
Other donors1.
Direct investment18.818.210.515.712.38.311.2
Bank sector66.314.823.027.326.931.820.0
Bond lending1.
Total resource flows100.00100.00100.00100.00100.00100.00100.00100.00
Source: Development Assistance Committee (1985).

Development Assistance Committee.

Organization of Petroleum Exporting Countries.

Council for Mutual Economic Assistance.

Non-Development Assistance Committee/Organization for Economic Cooperation and Development.

Less-developed countries.

Percentages for 1983 and 1984 have been calculated using a baseline figure for ordinary bank sector lending business, i.e., US$30 billion and US$17 billion after excluding from long-term flows estimated amounts rescheduled from short-term flows in those years.

Source: Development Assistance Committee (1985).

Development Assistance Committee.

Organization of Petroleum Exporting Countries.

Council for Mutual Economic Assistance.

Non-Development Assistance Committee/Organization for Economic Cooperation and Development.

Less-developed countries.

Percentages for 1983 and 1984 have been calculated using a baseline figure for ordinary bank sector lending business, i.e., US$30 billion and US$17 billion after excluding from long-term flows estimated amounts rescheduled from short-term flows in those years.

Developing Countries’ Demand for Foreign Capital

Three principal demand characteristics broadly corresponding to the term structure of lending and borrowing affect the developing countries’ demand for external capital.

First, developing countries have a demand for short-term capital. This is largely synonymous with the demand for trade credit by the public and private enterprises that make up the production and service sectors. Developing countries may also borrow to offset seasonal and other short-term fluctuations in output and, hence, in public revenue income and foreign exchange earnings. The funds are characteristically supplied from private sources (banks and exporters).

True short-term debt is self-liquidating as imported goods are sold or as seasonal cycles are completed. Even low-income countries can contract short-term debt, provided they have stable and effective economic management. Typically, short-term borrowing increases with a developing country’s growth and participation in the international economy, but its size relative to gross national product (GNP) and to exports stays roughly constant.

Some short-term borrowing, of course, is not for short-term purposes. Given particularly good balance of payments and debt management, this may not cause difficulties. A country or enterprise will eventually get into trouble, however, if it borrows to avoid dealing with underlying problems. In time, short-term borrowing then has to be transformed into medium- to long-term borrowing.

Second, medium-term capital from abroad may be used to provide liquidity for a “stretching-out” of costs, while an enterprise, a province, or even the national economy is correcting basic structural problems. Such borrowing may facilitate adjustment to changes in demand, supply, or other factors, the correction of past policy mistakes, or reconstruction after earthquakes or other “acts of God.”

The International Monetary Fund (IMF) has long recognized the need for medium-term financing for nation states. IMF drawings for medium-term adjustment were made subject to policy conditions to ensure that they were not used to avoid adjustment, so that borrowing countries would be able to liquidate their medium-term debt on schedule. To permit complex policy responses, the maximum period of such lending has gradually been lengthened to ten years. IMF drawings are available to all IMF members, but they have been used primarily by the developing countries, particularly in recent years.

Since the 1960s enterprises and governments of the more advanced developing countries have been able to borrow from private sources (principally through syndicated bank loans) for medium-term purposes. As long as enterprise or public policies ensure that the necessary restructuring actually takes place, the use of borrowed funds is irrelevant. As in short-term borrowing, if restructuring is not undertaken, the medium-term borrowing will need to be transformed into longer-term borrowing.

Because major investments usually have gestation periods of more than ten years, the third, and principal, demand for foreign capital is for long-term investment. Development takes time. A country’s need for investment grows as capital intensity increases with development. Capital for long-term investment may come in the form of official or private flows. It is usually used for expenditures on capital equipment, buildings, or infrastructure. But an enterprise may also use it for working capital, and a government may properly use it for recurrent expenditures in some instances. For example, the education sector may require expenditures that appear as recurrent items in the budget even though, in fact, they are an investment in human capital.

Each type of capital flow has its own demand schedule. Political as well as economic factors enter the calculus. For example, the effective demand for aid reflects both the developing country’s ability to demonstrate how much aid it can absorb (aid diplomacy) and its social, political, and economic ties to the donors. As a country becomes increasingly able to service private capital flows, demand schedules for various types of private capital evolve. The demand for direct investment varies considerably by sector, and is associated with that for advanced technology, management, and access to foreign markets. Thus, demand for direct investment in natural resource exploitation differs from the demand for investment in import-substituting manufacturing and from that in export-oriented manufacturing. Export credits, banking flows, and bond issues also have their own demand schedules.

A country’s total external borrowing—official plus private—can be expected to expand for 30, 50, or more years until productivity and living standards approach those of the most advanced countries. When the development process is essentially completed, a country will cease to be a major net borrower abroad. A country may become a net lender as its savers and entrepreneurs find that their capital can earn a higher income in other, less developed countries than at home. However, while international borrowing and lending transactions by private and public entities continue, over time they will tend to come into balance.

In a competitive environment without major policy distortions—where prices reflect costs, and costs reflect productivity—the demand for external capital is related to marginal socioeconomic costs and returns. These, in turn, are close to marginal private costs and returns over a wide range of activities. The demand for foreign capital is then optimal. An adequate capital servicing capacity is created automatically. Short-term liquidity problems may occur from time to time, with abrupt demand or supply changes or in periods of serious international recession. But these do not reflect underlying solvency problems. Savings, investment, and foreign borrowing march together, in step with the growth of exports and national product. In a formal sense, the marginal socioeconomic return on domestic and on foreign capital will be the same, and it will be equal to the real marginal cost of total borrowing. The real world is, of course, more complex than this theoretical construct. Market imperfections exist. In many developing countries poor domestic policies have created an excessive demand for foreign capital. The principal distortions originate in financial, trade, and fiscal policies.

In countries with “repressed” financial systems, savings tend to flee the country or remain outside the monetary system. Those savings that do remain in the country are usually poorly distributed. Domestic capital is thus difficult to obtain. Rationing has to substitute for market mechanisms. Only a few privileged enterprises can obtain domestic capital through the banking system; all others must pay very high “curb” interest rates. As a result, most firms seek financing abroad.

If the developing country has highly protectionist trade policies, incentives to invest in the protected domestic market will be strong. Foreign direct investors—as well as local investors—will wish to enter into production in such countries. Capital inflows will be further encouraged if the developing country guarantees the repayment of private debt. Even if the protection is at least partially offset by export incentives, resource allocation is likely to be distorted. Private returns on foreign borrowing will probably exceed social returns. But protection undermines the country’s foreign debt servicing capacity by discriminating against its exports. Thus, liberalizing access to foreign capital without also liberalizing trade is particularly conducive to excessive borrowing abroad (McKinnon (1982)).

Inappropriate fiscal policies also often encourage excessive foreign borrowing. Developing countries frequently give tax holidays to investors in “essential” industries, thereby not only forgoing government revenue, but also attracting inappropriate direct foreign investment (particularly if there is protection) and encouraging foreign borrowing by local investors. If a country does not have a strong taxation base, there will also be intense pressure to borrow abroad for public investment, particularly if the government has taken over “basic industries” to bring them under national and/or indigenous control (Freeman (1985)). Moreover, the lack of a strong tax base usually leads to inflation, which together with restricted financial policies and protective trade policies contributes to the overvaluation of the exchange rate. And an overvalued exchange rate further increases the demand for borrowing abroad.

Dutch Disease encourages excessive external borrowing in mineral-rich countries. Mineral rents tend to encourage highly protectionist, financially distorted, fiscally inappropriate government policies. Excessive expectations of growth in times of high mineral prices have often caused borrowing to increase much more rapidly than future income could possibly grow. Then, if mineral prices fall (cyclically or because supply is increased or demand falls), public and private revenues and savings fall; the demand for capital increases to sustain investment and even consumption. Many mineral-rich countries have, therefore, become high borrowers.

Policies that lead to excessive borrowing also result in low returns on investment because of distorted resource allocation, low factor utilization, and a low propensity to export. The ability to service borrowing is thus much lower than in countries with more appropriate policies. Since most individual developing countries represent so small a component of demand that they are largely able to determine the amount they borrow (Riedel (1983)), their domestic policies are the principal determinants of borrowing levels.

Overall, the share of net capital inflows in gross domestic investment increased in the 1970s (Table 1). In sub-Saharan Africa and Latin America this reflected low domestic savings rates and, respectively, rising aid and rising private inflows. But in the other regions, capital inflows grew side by side with ratios of savings and investment to GNP.

Supply of Foreign Capital

Political as well as economic factors affect not only the demand for external capital, but also its supply. Concessional and nonconcessional official flows, for example, are often largely politically motivated; military/strategic issues often loom large in the determination of recipients and volumes of flows. They usually also have an economic component: donors expect future trade or investment gains. Humanistic factors are clearly also important, particularly in the allocation of aid to small, poor, and distant countries.

Savers—individuals, institutions, and governments—are the ultimate source of capital flows to developing countries. They seek high returns and liquidity. Borrowers seek precisely the opposite: namely, low costs and long maturities. Financial intermediaries intervene to reconcile these widely diverging requirements (Llewellyn (1984)).

Transnational corporations invest directly through their subsidiaries and associated companies or through management contracts and similar arrangements. The savers in this case are interested not only in returns on capital, but also in returns to entrepreneurship, in mineral and other resource rents, and in quasi-rents associated with new technology, trademarks, and so on—all subject to prudential considerations.

Financial intermediaries proper, notably banks, transform savings into loans. Their fee is the difference between deposit and lending rates, plus management, commitment, agency and other fees, and profits on ancillary business such as foreign exchange transactions. They arrange capital flows and associated services from the ultimate lenders to the ultimate borrowers such as private and public enterprises, including other banks and governments. However, they are not simply brokers in a perfectly informed and otherwise perfect market. They are also profit maximizers, so that in transforming short-term lending into long-term borrowing they must ensure their own liquidity. They have to trade off spreads and fees against the volume of business, and volumes and spreads against risk. Failure of their clients to service loans on time, ultimately becoming bankrupt or defaulting, is a critical element in the banks’ profitability.

Creditworthiness—be it of an enterprise or a country—is a highly-subjective concept, particularly ex ante. Therefore, all lending is risky. But lending abroad entails special additional risks. Some of these risks are “systemic;” that is, they apply to all the loans in a country or groups of countries. “Transfer risk” represents the danger that a debtor country will not make sufficient foreign exchange available for servicing debt. “Country risk” encompasses those dangers to which a lender is exposed because of unique legal and other institutional obstacles to the collection of debt service in the debtor country. “Sovereign risk” is associated with lending to a government rather than a private borrower (Heller (1982)). Other risks can be offset if lenders diversify their lending within or across countries.

Lending abroad thus has prudential considerations in addition to those of matching capital and liabilities to assets, and of distributing loans among individual enterprises and between public and private borrowers. Moreover, like private direct investment, it has long-term perspectives; it looks to the borrower’s future as well as current economic position.

The supply schedules of capital are globally determined. Lending to developing (and centrally planned) countries is part of a continuum encompassing capital flows within a particular industrial country, other industrial countries, and the rest of the world. The basic price of capital is decided in the industrial countries by their supply and demand for capital, both of which are affected by these countries’ financial and monetary policies. Margins over this basic price (including spreads and fees), however, are loan-specific, varying both across countries and over time. Some developing countries (such as Malaysia) have, on occasion, paid less for foreign capital than some industrial countries (such as Italy).

Because there is essentially only one global supply schedule for each type of capital instrument, the macroeconomic policies in the industrial countries that affect their own various demands for capital also affect the supplies of capital available to developing countries. Thus, the industrial economies’ failure to deal with the problems that beset them from the late 1960s (inflation, price inflexibility, unemployment), followed by their failure to adjust to increased petroleum prices in the mid-1970s, led to their low demand for capital for domestic investment. This occurred at the same time the low capital absorbers among the petroleum exporters were placing their savings in financial intermediaries in industrial countries, making the international capital markets very liquid. The Eurodollar markets were thus able to respond very readily to the increased developing country demand for private capital in the mid-1970s and to sustain it into the 1980s. Then petroleum export volumes declined and real petroleum prices sagged. The industrial countries again became net savers and substantial capital exporters from the later 1970s (Watson, Keller, Mathieson, et al. (1984)). Their policies—or lack thereof—were not conducive to domestic investment. Large capital inflows into international capital markets, together with a general lag in the perception of inflation and permissive monetary policies in industrial countries, led to low and even negative real interest rates, encouraging developing country borrowing. Thus, from a global and long-term perspective, too much capital probably flowed to developing countries during the mid- and late- 1970s. The pro-cyclical policies of the World Bank and the IMF contributed to excessive borrowing. Both organizations, though the IMF less so than the World Bank, increased lending, competing with each other and the commercial banks and forgoing conditionality in the process.

Nation states have established central banks to safeguard borrowers and lenders against market imperfections and disruptions. They also have expanded their regulatory systems to control financial intermediation associated with international capital flows. These regulations were considered excessive by private financial institutions and, hence, led to the establishment of offshore banking centers and the Eurodollar markets in the late 1950s and 1960s and other developing country centers such as Bahrain and Singapore in the 1970s.

Some country-related prudential rules, such as “country exposure” limits, have had only very limited intended effects, and have, instead, further pushed business into offshore markets. Tax holidays and other benefits to direct investors abroad have helped encourage direct investment at the expense of bank lending, whereas official guarantees and subsidies for export credits have expanded export credits (and associated bank lending) at the expense of direct investment. Industrial countries also provide guarantees and political risk insurance, particularly for export credits, but also for some other loans to developing countries; in shifting the cost of nonpayment from financial institutions to taxpayers, this has introduced “moral hazard” and encouraged lending beyond levels that would otherwise have taken place. The motivations and the design of the policies that attempt to regulate capital movements to developing countries have been too vague, contradictory, and complex to have had much intended effect, but they have substantially weakened the analysis of creditworthiness by lending institutions and therefore led to excessive lending.

An optimal level of borrowing from a country’s point of view is far from synonymous with creditworthiness from a banker’s point of view. A country may be able to continue to service its debt by taxing its population (at least, for a time), although it has borrowed excessively and/or used its borrowed funds for purposes with low socioeconomic returns. That is, it may be creditworthy, though it has borrowed excessively. While in a loose, arithmetic sense a country can afford to borrow as long as the growth of income exceeds real interest costs (Avramovic (1958)), or even as long as borrowing covers service payments (Kharas (1981)), in economic terms a country has to earn more on its borrowing than the inflows of capital cost if the borrowing is to be worthwhile.

International Capital Market Trends

A growing number of banks entered into international lending from the mid-1970s as its relatively high profitability became recognized, first in the United States and then in Europe, Japan, and the expanding developing country money markets. This led to highly competitive conditions, driving down margins over the London interbank offer rate (LIBOR) and fees to very low levels from 1976 onward (after recovery from the Herstatt and Franklin banking failures).

A number of new instruments were developed to facilitate international lending and borrowing. International bank syndications, following U.S. domestic lending practices, were introduced to facilitate risk-spreading and to finance very large projects and large loans to governments. Small and inexperienced banks were able to enter international business gradually. The London interbank market helped the individual banks to handle short-term liquidity changes. Variable interest rates were introduced to offset the risks associated with fluctuations in inflation. The interbank market also dealt with currency fluctuations caused by floating exchange rates when these were introduced in the 1970s. As banks wanted to continue to expand lending to clients once they established a good business relationship, rollover or refinancing practices became commonplace. This reduced the importance of loan maturities and facilitated planning for both lenders and borrowers. The ease of rolling over private loans contrasted markedly to the cumbersome rescheduling of official loans through the administrative channels of the Paris Club of donor governments.

Extremely low real interest rates transferred income from savers to borrowers. To the extent that petroleum exporters were savers and petroleum importers were borrowers, this income transfer helped offset the increase in petroleum prices. Bank profitability was maintained by the high front loading of fees and by high nominal interest rates, which in effect led to the prepayment of amortization (Nowzad, Williams, et al. (1981)). Overall, borrowing was shifting from direct investment to bank loans and private export credits (Tables 2 and 3). Taxation policies in developing countries also encouraged this shift; dividends were taxable as profits, while interest payments on loans were deductible as costs. There was little conditionality in private bank lending, so that the IMF’s and multilateral banks’ loss of leverage was not compensated. The only discipline that was imposed was largely that of the borrowing countries themselves. For example, since the mid-1970s. East Asia has used IMF facilities twice as intensively relative to GNP as has Latin America and the Caribbean. For the period 1971–81, East Asia, Latin America, and the Caribbean made the same amount of IMF purchases, with East Asia making most of its purchases in 1980–81. However, East Asia’s purchases (net of the reserve tranche) represented a 0.25 percent share of GNP, whereas Latin America’s was only 0.10 percent.

Very low, and sometimes even negative, real interest rates could not last. The Federal Republic of Germany, Japan, and a few other industrial countries had begun to use a combination of fiscal, income, and monetary policies in the mid-1970s to fight inflation. In the other industrial countries, the problems of low growth with increasing unemployment and high inflation came to a head after the second petroleum price increase. Only then did the United States act, largely relying upon monetary policy (because it was unable to control fiscal deficits for political reasons) to bring down inflation. This, together with a new appreciation of the costs of worldwide inflation, raised real interest rates even faster than they had fallen in the mid-1970s. The tight monetary policies deepened and prolonged the post-1978–79 recession (in contrast to the short, sharp trough of 1975), catching the developing countries in a scissors movement; their interest payments rose sharply just as the recession, exacerbating a cyclical downturn in raw material prices, slashed their export earnings. Many countries were now much more “borrowed up” than they had been in 1975, and they accordingly slowed their rate of borrowing. At the same time, some lenders became concerned with the liquidity and solvency of the high borrowers, and further raised the cost of borrowing from 1978. Savings in management and other fees and in spreads over LIBOR only slightly compensated for high interest rates, with a resulting move back to direct investment and export credits. At an 8 to 10 percent nominal interest rate, export credits became very economical as industrial countries strove to sell abroad in a mercantilist reaction to higher petroleum prices. Net transfers less interest payments to developing countries declined sharply as their interest service on debt rose; in some instances they even became negative. When nominal interest rates again began to fall in 1982, the savings on debt service were considerable. Borrowing, nevertheless, declined in 1982, mainly because of the difficult position of the principal Latin American countries.

Borrowing from private sources (including short-term as well as medium- and long-term) was highly concentrated. Three countries (Mexico, Brazil, and Argentina) accounted for more than 50 percent of the developing countries’ borrowing. Another four countries (Venezuela, the Republic of Korea, Chile, and the Philippines) accounted for another 20 percent. The low-income countries of Asia have participated little in the international markets thus far, particularly in comparison to the low-income countries of sub-Saharan Africa. India, for example, has argued that its financial structure and protection of domestic industries do not permit the entry of private direct investment or other private capital. China has similarly maintained a very cautious stance to foreign borrowing.

Capital Flows to Developing Countries and Current Account Deficits

The connection between foreign financing for development and current account deficits and surpluses is tenuous. Current account balances reflect the working out of trade, remittance, and capital service flows. Deficits can occur only if they can be financed. The current account data used here exclude grant aid, so they cannot in any case be used as proxies for the financing needs of developing countries. Developing country deficits remained fairly small as a share of GNP (Table 4) until the recession of 1975, reflecting the limited absorptive capacity of most developing countries for foreign borrowing. The high deficits from 1980 reflect several factors: the unintended prepayment of amortization through high nominal interest rates shifted payments from the capital to the current account; the tropical beverage boom of 1977–78 and high private and official flows to 1978 led to (lagged) high import flows in 1979 to 1981; primary product prices, which had been falling since the 1972–73 primary product boom, bottomed out in 1981–82; the recession reduced the volume of demand for developing country exports; and real interest rates rose. When the possibility of a liquidity problem was predicted (Long (1980)) in the late 1970s, it was ignored. When the problem did arise, the World Bank, in particular, found that it had overextended its lending. Not only did it have institutional difficulties in terms of its capital base in maintaining borrowing, but many of its client countries could not support local funding for the projects on which they had embarked. The lack of effective conditionality in countries, such as Tanzania and the Philippines, had weakened rather than strengthened developing economies through structural assistance loans. Difficult as these conditions were to handle in the short run, they should not be equated either with long-run external financing requirements for all developing countries or with general developing country solvency. However, for countries that had not adopted sound growth and development policies in the 1960s and 1970s, the early 1980s did result in serious solvency as well as liquidity problems.

Table 4.Current Account Balances1 as a Share of Gross National Product, 1960–84(In percent)
Country Group196019701975198019831984
Low-income countries–1.6–1.1–2.1–2.2–1.0–1.3
Africa, south of Sahara–3.3–3.4–10.2–9.8–10.0–9.4
Middle-income countries
Oil importers–2.9–3.2–5.3–4.1–4.4–2.7
Oil exporters–2.7–3.2–5.5–3.6–3.1–1.3
All developing countries–2.2–2.3–3.9–2.3–2.8–1.8
Source: World Bank (1985a).

Excluding official transfers.

Source: World Bank (1985a).

Excluding official transfers.

IV. External Debt and Creditworthiness

Borrowing leads to the accumulation of debt as surely as night follows day, though in some international circles the earlier cry for better developing country access to private capital markets (Avramovic, et al. (1964)) has now been replaced by astonishment at the size of the developing countries’ debt! In constant price terms, medium- and long-term debt grew at about 24 percent a year from the mid- 1960s to 1972 and at 18 percent from 1973 to 1983 (Table 5). The 1965 to 1972 growth rate partly reflects the low initial base, the progressive addition of countries to the data base throughout the period, and the inclusion of private non-guaranteed debt in the data from 1970. Nevertheless, the growth of total indebtedness in the 1970s was not as rapid, either in real terms or in relation to the experience of the 1960s, as is frequently thought. Access to and the use of international banking flows and the relative shift in recent years from direct investment to bank borrowing have increased debt (while slowing the increase in the stock of investment held in developing countries by transnational corporations). Rising shares of debt are, of course, owed to private sources, on nonconcessional terms and at variable interest rates.

Table 5.Growth of Medium- and Long-Term Debt of Developing Countries, 1965–831
Total Disbursed Debt

End of Year
Average Annual

Growth Rate
(In billions of U.S. dollars)(In percent)
Low-income countries
Africa, south of Sahara1.
Middle-income countries
Oil exporters10.830.6321.325.626.5
Oil importers3.957.8209.329.413.7
All developing countries21.6109.2597.623.618.5
Source: World Bank (1984, 1985b).

Data prior to 1970 exclude private nonguaranteed debt.

Author’s estimates.

Includes China.

Source: World Bank (1984, 1985b).

Data prior to 1970 exclude private nonguaranteed debt.

Author’s estimates.

Includes China.

Debt, as a share of developing country GNP, grew as countries began to borrow (Table 6). But the ratio of reserves to debt also rose for most groups of developing countries until 1981, and the ratio of debt to exports declined until the world recession became fully felt in 1982. Countries that wanted to borrow needed a more rapid growth of exports and had to maintain higher ratios of reserves to imports. Thus, their borrowing was a force for outward-looking policies, often overcoming domestic protectionist pressures. In this sense, at least, debt has been an engine of growth; countries with rapid export growth have grown faster than others; several have taken advantage of international capital flows to achieve high export growth. Industrial country lending to developing countries also damps protectionism; the lenders want to get paid.

Table 6.Debt Indicators, 1973–83(In percent)
Country Group197319831973198319731983
Low-income countries
Africa, south of Sahara104.13612.415.938.028.96.9
Middle-income countries
Oil importers98.5161.418.640.355.519.8
Oil exporters103.5158.520.238.238.519.3
All developing countries110.6174.518.636.543.919.7
Source: World Bank (1984, 1985b).
Source: World Bank (1984, 1985b).

Given the increasing reliance on market financing, plus the general rise in interest rates, debt service has grown faster than debt. Debt service growth, however, was offset in part by a slowed growth of dividends and capital repayments on private investment. Total debt service ratios (interest plus amortization divided by exports of goods and services) have thus grown less than bank borrowing service ratios imply (Table 7). Even bank debt service ratios remained stable in East Asia and the Pacific, although they rose markedly in all other regions. The interest service ratio (interest payments divided by exports of goods and services), highly relevant in a market in which refinancing is a routine operation, grew more rapidly than total debt service with the adoption of variable interest rates, particularly for Latin America. Despite the coincidence of high interest rates with a more prolonged recession than any since the 1930s, most developing countries have been able to service their debt without interruptions; only those that have borrowed excessively because of their inappropriate domestic policies have run into trouble.

Table 7.Debt Service and Interest Ratios, 1973–83
Debt Service RatioInterest Service Ratio
Country Group1973198319731983
Africa, south of Sahara9.923.62.810.1
East Asia and the Pacific11.312.53.25.8
Latin America and the Caribbean24.236.17.823.5
North Africa and the Middle East16.
South Asia17.238.56.515.2
Europe and the Mediterranean12.325.63.512.4
All developing countries16.224.94.913.1
Source: World Bank (1984, 1985b).
Source: World Bank (1984, 1985b).

As a group, the developing countries hold substantial assets in the industrial countries and earn income on them. Table 8 indicates the official and declared funds that developing countries hold in industrial country banks (including certain offshore branches of U.S. banks). A high proportion of privately held assets are excluded from the table, because such assets are registered as domiciled in the industrial countries. Some offshore banks that are major depositories for private developing country assets abroad are not included (World Bank (1985b)).

Table 8.Developing Country Assets and Liabilities with Industrial Country Banks, End-September 19841(In billions of U.S. dollars)
Country GroupAssetsLiabilities
Low-income countries
Africa, south of Sahara43
Middle-income countries
Oil importers
East Asia and Pacific2970
Middle East and North Africa2120
Africa, south of Sahara38
Southern Europe1439
Latin America and Caribbean43212
Oil exporters163178
Source: Bank for International Settlements (1985).

The figures exclude all centrally planned developing economies. Also excluded are the following offshore banking centers: The Bahamas, Bahrain, Barbados, Cayman Islands, Hong Kong, Netherlands Antilles, Panama, and Singapore. The industrial country banks include certain U.S.-owned offshore affiliates.

Source: Bank for International Settlements (1985).

The figures exclude all centrally planned developing economies. Also excluded are the following offshore banking centers: The Bahamas, Bahrain, Barbados, Cayman Islands, Hong Kong, Netherlands Antilles, Panama, and Singapore. The industrial country banks include certain U.S.-owned offshore affiliates.

Debt Problems

The largest number of countries with debt problems are low-income countries, most of them in sub-Saharan Africa. Their debt difficulties are linked with their extreme poverty and development problems. For a number of years, their income growth has lagged behind their population growth; in some cases it has even been negative. The 1981–82 recession with its low primary product prices was for many the last straw. These countries still owe debt mainly to official lenders on concessional terms, though they have also done some borrowing from private sources, particularly in the form of subsidized export credits. These countries were never creditworthy. In nonguaranteed markets they would not have been able to borrow commercially and would have encountered serious problems. Some of these countries, despite debt service ratios of less than 10 percent, have repeatedly fallen in arrears. A dozen or so have had their official debt either forgiven or rescheduled and their private debt refinanced, often several times, usually with IMF assistance. Although these countries are numerous, their total population is small and they represent less than 5 percent of total developing country debt.

A second group of countries with debt problems is made up primarily of middle-income countries. It includes several mineral-rich and relatively advanced countries, notably Brazil, Mexico, and Argentina, which ran into serious liquidity problems in the 1980–82 recession, requiring large IMF drawings and refinancing arrangements with private banks. These countries vary quite widely in debt to GNP ratios and in debt service and capital service liabilities. However, they share an ineptitude in economic policy that led them to borrow heavily. When they subsequently fell into economic difficulties, domestic crises turned into debt problems. In Brazil and Argentina, particularly, serious solvency difficulties arising from inappropriate economic policies also underlie liquidity problems.

Despite the difficulties created by some of the large borrowers, a generalized debt crisis involving widespread developing country default (though predicted regularly since the mid-1960s) has been avoided. However attractive individual default may have seemed to some countries in the short run, it would have cut such countries off from all credit for a long time, and thus represented a very high-cost strategy. The costs of individual default would also be very high in terms of sequestration of assets. Cuba, which took this route, is advising fellow socialist countries against such a course of action. Mass default would severely constrain the institutions lending in the international capital markets, but would not cause their collapse (c.f., Eaton and Gersowitz (1981)).

As export markets have picked up and real interest rates stabilized, most developing countries have been able to continue to be net borrowers. The developing countries thus do not present a threat to international financial intermediaries. Despite some arrears and nonpayment situations that have sometimes led to the writing-off of bad loans, developing country lending remains more profitable than domestic lending. Many developing countries are still growing faster than the industrial countries and are likely to continue to do so. Another group is likely to graduate to borrowing from commercial markets on a significant scale by the end of the 1980s. Failures of large corporations in the industrial countries, where more than 90 percent of their lending lies, pose a greater threat for international banks than do the developing countries.

The IMF was established to be the world’s international central bank. It has fulfilled part of this function through its financial operations, national consultations, and international surveillance over trade restrictions and monetary policies. It has not picked up all the responsibilities of a world central bank, and the Bank for International Settlements, therefore, also plays a major role in international finance, by providing a forum for consultations among the central banks of the industrial countries in which the headquarters of most major international financial intermediaries reside. The new money market centers in developing countries should now be brought into these consultations. Paradoxically, however, most of the prescriptions for improving the international debt situation, such as proposals for moratoria on existing debt, buying out private debt by multilateral public institutions (so that private banks could start lending to developing countries again), and other safety nets are inappropriate. They would subsidize and even encourage wasteful national managers, and in the long run they would penalize the careful ones. Like other additional national or international guarantees, they would exacerbate the already high moral hazard that has led to excessive borrowing and lending (Dorrance (1981)). Attempts to “privatize” the profits of international banking and “socialize” the losses would jeopardize the continued use of foreign capital for growth. There are no quick fixes for development problems. If external capital is to continue to flow to developing countries, many of them will have to improve their domestic policies, and financial intermediaries will have to learn to be more discriminating than they have been in the past.


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Christopher Findlay

I. Introduction

Helen Hughes’ theme is that external capital flows can contribute markedly to growth, even though such flows might be a marginal component of total investment, as long as the host country is “well run,” or in other words, as long as the policy environment in the host country causes the capital inflow to be used efficiently. I would like to comment on two topics: first, the forms in which capital flows into developing countries; and second, the problem of creating the correct policy environment.

II. Forms of Capital Flows to Developing Countries

Hughes presents a model of the evolution of capital flows, which I characterize in the figure below (Chart 1). In the first stage of very low income, the developing country has two main sources of external funds—trade credits and official development assistance (ODA)—since at this stage the country appears unattractive as a place to invest in (unless it is relatively resource-rich) or to lend to in the absence of tangible security, like exportable products. The availability of private capital increases in the second stage and direct investment becomes more important, but the original sources also remain significant. At later stages of development, as the creditworthiness of the country increases, there is a shift in this model away from direct investment and “tied” funding such as aid to bank borrowing and, indirectly through the banks, bond finance.

Chart 1.Shares of Capital Inflow by Stage of Development


This description of the model stresses the role of growth in determining the mix of capital inflow. However, as Hughes also points out, these forms of capital inflows are not all perfect substitutes and there will be a demand and supply schedule for each type of finance. The precise mix of sources of funds will also vary with their relative prices, and with specific supply and demand factors. For example, an increase in the liquidity of the banking system, new financial instruments, increased efficiency in banking, and changes in the regulatory environment could lower the cost of debt relative to other forms of inflow and increase its share at all stages. ODA also has a “price,” as Hughes also stresses, which could change over time. To be more precise in predictions about the composition of the capital flows, the specification of those schedules and the time periods involved in each stage would have to be considered in more detail.

Hughes argues that on the supply side, there is essentially one global supply schedule for each type of capital instrument. However, there is evidence that capital flows, like trade flows, tend to be regionally concentrated. This is intuitively plausible for trade finance, direct investment, and aid, although perhaps less so for debt. Even there, risk assessment will depend on familiarity with the borrowing country, which will be greater for borrowers in the same region, or for borrowers with whom the lender has a longer history of economic contact (e.g., excolonies, members of the Commonwealth). Hence, the supply schedule facing a developing country might depend more on forces operating in the developed countries in its region (e.g., Japan in East Asia) than in such countries further away. (See Pangestu (1980) for evidence of the tendency for Japanese direct investment to be concentrated in the region.)

Hughes presents data on the composition of capital flows to developing countries (Tables 2 and 3, pp. 128–29 and 130–31). It might be tempting to use these data to attempt to infer whether the Hughes crosssection model of the composition of capital flows is a useful description of changes in the resource flows to developing countries (DCs). But there are problems in doing so because the time series reported contain data from a number of countries at different stages. Also, the data reflect changes in the relative costs of various sources of funds, whatever the level of development, that is, vertical movements in the boundaries at all stages of development as depicted in Chart 1 which ideally should be separated from the composition of countries in the sample.

The data reported by Helen Hughes are reproduced in summary form in Chart 2), The bar charts show the volumes of various private flows, aggregated into direct investment and “other private,” which is mainly bank lending, as well as private voluntary assistance (PVA). The official flows are classified as ODA, export credits (which are included under “nonconcessional flows” in Hughes’ tables), and other official (also included under “nonconcessional flows” in Hughes’ tables).

Chart 2.Resource Flows to Developing Countries


The top bar chart shows the long-run changes since 1960, and the lower chart shows the changes for selected years in the 1980s. (The selection of every second year hides some variation, which is apparent in the raw data.) The two charts show the rapid growth in resource flows to developing countries (at an annual average rate of about 5 percent a year over the 20 years from 1960) due to growth in all categories except direct investment and PVA. They also show the stability in those real flows over the 1980s. The charts illustrate points made by Hughes, e.g., the significance of ODA, the rapid growth in private lending over the 1970s, and the fluctuations in private lending in the 1980s. The pie charts (Chart 3) show the changes in shares of inflows due to each source between 1960 and 1984. The significant changes are the drop in the share of official sources, especially ODA, but also nonconcessional funds; and the increase in the share of bank lending, but also the fall in the share of direct investment. In summary, there has been a shift to private sources, away from official sources and from direct investment.

Chart 3.Shares of Resource Flows to Developing Countries

(1960 and 1984)

What I found surprising in these charts was the low and declining share of direct investment in resources transferred to DCs. Hughes discusses the optimality of the total flow of resources to the DCs, but does not discuss explicitly and in detail whether the composition of the flow is biased. For a number of reasons, there would be a bias away from direct investment toward debt. The possibility of such bias is important, because of the lack of substitutability between the forms of capital.

For developing countries, direct investment has a number of advantages over debt. It is accompanied by transfers of knowledge or technique, which would otherwise not be available to the capital importer. Hughes says that this information would also be available alongside bank lending or aid flows, but this seems unlikely. For that to happen, the capital and the information, or skill, would have to be separated out and then the original owner of the information asset would be more likely to forgo the quasi-rents on that information and therefore be unwilling to reveal it. Also, a foreign investor shares more of the risk in a project with the host country and its citizens, and therefore places a smaller burden on the country in periods of low commodity prices, etc., contrary to the experience of highly geared countries. Finally, direct investment has more direct effects on trade than debt, because the foreign owners often wish to export the product back to their home country. (Park (1986) tests hypotheses about connections between the intensities of trade, aid, and direct investment in bilateral relationships.)

A bias against direct investment could occur because various policies in the host country tend to discriminate against direct investment, for example, rules on local equity. These can often have the effect of putting more risk on local investors (or of dissipating some of the rents from the project in inefficient risk-sharing) and of distributing foreign ownership across more sectors of the economy than originally might have been the case. From the investor’s point of view, the main problem associated with direct investment is the risk of being caught with an obsolescing bargain, a problem also referred to by Hughes as the high level of sovereign and country risk.

While direct investment flows are burdened by these imposts, debt receives an implicit subsidy from the guarantees offered, or expected to be offered, by central banks and international agencies. These taxes and subsidies change the relative prices of debt and equity, so that the share of direct investment in total flows ends up being too low. To return to the Hughes theme, foreign capital inflows could contribute even more markedly to growth if this bias were removed. But removal of the bias requires a change in the policy environment.

III. The Policy Environment

Policy advisers and politicians are increasingly aware that biases toward import-substituting industries will hinder growth (see, for example, Ariff and Hill (1986)). Hughes notes that a protectionist trade policy, along with a repressed financial system and inappropriate fiscal policies, will distort the volume and direction of the capital inflow. However, the making of economic policy takes place in a political market, which can produce policy sets radically different from those that will maximize growth, even though the rhetoric of the political leadership is in favor of growth (see Findlay and Garnaut (1986) for a review of the experiences of Association of South East Asian Nations (ASEAN) and Australia). The policymaking challenge is then to shift the policy set toward the growth-maximizing package.

A traditional approach to setting the agenda for policymaking is to use the work on the economics of the second best. However, this approach is excessively conservative. It limits the extent to which policymakers can use the influence of events in markets for substitute goods and services to facilitate across-the-board liberalization. For example, strict application of the rule from the traditional static second-best world would have inhibited the liberalization of Australia’s financial sector because it would have restricted the growth of substitute financial assets. This growth put pressure on the banks to argue for liberalization of their regulatory environment (see Harper (1986)). In other words, for long-run growth, it may be worth putting up with an increase in short-run distortion in the allocation of resources. This argument applies to the process of tariff reduction within the import-competing sector. It could also apply at an aggregate level; for example, it could be used to support the deregulation of markets for capital whether or not a distortion in the labor market continues to exist.

With respect to direct foreign investment, the “substitute principle” can also be applied by identifying motives for policies that inhibit the use of such funds. If the motive of local equity rules, for example, is to capture more of the benefits of projects for host countries, this directs attention to the use of more efficient fiscal devices (e.g., resource rent taxes in mineral projects) as a substitute form of intervention. Fiscal instruments are then an important part of the agenda for reform.

It is difficult to define an effective agenda for policy change. More work on the operation of the political market for structural adjustment policy would be useful for that purpose.


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