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CIRCULA-ING CiPYTO RB RETURNED TO REPORTS DES9

IN GENERAL FILES Repo EC1.21CIMMAT1NG COPYTO -- AllNG calPY Revised

'To IKE REITURNEWD TfJ ARIC1H'TrE nuly"IS"ItON

Tnis report may not be publisned nor may it be quoted as representing tne view at

the Bank and its affiliated organizations. They do not accept responsibility for its

accurocy or compieteness.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

INTERNATIONAL DEVELOPMENT ASSOCIATION

AND

EXTERNAL DEBT

VOLUME I

An Analytical Framework

Staff Study of the Economic Department

March 12, 1964

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ECONOMIC GROWTH AND EXTEINAL DEBT, VOLUME IAn Analytical Framework

A Staff Stuidy prepared in the Econnm.lr Depanrtmpnt. by:

Trha JO sl av Avramovi c

Assisted '-r: RavL rii Gl.

J. Philip HayesS. Sf-a,4d Tusain

Edited b>J: Lnora Whte~~'-~ * .L.1 L . 'J 0 V IJ.L LA,

Computer Wtor'K S. Shl H 4 sA LTi

Donald Niewiaroski

Charts: Lillian OldhamBnarat Kris'rmna

TABLE OF CONTE NTS

Pag-e

I. Introduction 11 lerms of reference L2. Factual background 23> Theoretical background 34. Limitations 5

II. Conceptual Framework 7

III. The Liquidity Aspect of Debt Servicing Capacity 91. Variables 92. Fluctuating variables (disturbance variables) 10

(a) Export declines 1.0(b) Swings in capital flows 25(c) Emergency or inflation-induced import increases 17

3. Offsetting variables (compensating variables) 1.8(a) External reserves 18(b) Compensatory finance 21(c) Compressible imports 22

4. Rigid variables 24(a) '"Kinimum tolerable" level of imports ,)4(b) Debt service - interest 2)4(c) Debt service - amortization 25

5. Inter-relationships among the liquidity variables 29

IV. Debt Service Ratio 321. Rationale .322. Limitations :333. Long-run relevance .35

V. The Long-Term Aspect of Debt Servicing Capacity 391. L.vpl of analysis 392. Macro-econcmic benefits 393. A digression: the adiustment Droblem4. Macro-economic costs and their time-sequence 425. The extremes and the. "tvninalfl as ILI

6. The model and its assumptions 467 Tnimng )188. Qualifications 529. Gross vs. net borrowing 53

lO Debt service ratio revisited 53

VI. Conclusions 63

Page

List of Tables in the Text

1 Recent Short-Term Export Declines, from Peak to Troughand Degree of Commodity Concentration of exports. 11

2. Jvia :iimum Percentage Short-Fall of Merchandise ExportEarnings from Export Trend, (1 to 4 years, cumulative)and Commodity Concentration of Exports. 12

3e Coffee: World Export Values. 143a. Export. Indices, Quantity and Value, for Coffee and Major

Commodity Groups. 1144. Conditional and Unconditional Liquidity as a Percentage

of Imports. 195. Imports of Non-Food Consumer Goods, 1961, Selected Countries. 236. Debt Structure, Public Debt Service Ratios, Exchange Reserve

Ratios and Export Growth Rates. 307. Debt Service Ratios. 1961 and 1962. with Varving Degrees of

Coverage of Debt Service Transactions, 378Q Ratios of Public Debt Service to Exports in 8 Latin American

Countries in the 1920's, 1930's, and 1950's, in percentages. 3i39. Some TndiGators of Rncnominc rowth. 59

l0o Some Data Bearing on Creditworthiness over the Medium andTLnrog-Runn 61

lOa. Exports as a Proportion of Gross Domestic Product 62a

List of Charts

I. The Debt Cycle (6% per annum repayable in 15 years). 49II EL-ie Level of-1 Capitl Infl 'ow in R'lelation to Docmestic~

Savings and Investment. 5DIII. Investrrient, Savings and Capital InfMow in the Process of

Economic Development. 5LRLV iat-los ofL Debt, ServiLce Pa-ymlents tolkiZ Gros "oesicu ProdII uct

Savings and Exports. 514V M ovement of utstanding Debt in Relation to Gross Donmestic

Product. 57

r--4

CHAPTER I. INTRODUCTION

1. Terms of Reference

1. This study was prepared in response to a request from theDevelIopment- Alssistarce Cr,__tee..- (TDAC)\ of 4he C-grzto for4./~~ L0JiU~i U udLL %OUIILALL U UU ~.IJk3U/ 0±V ULM-, V.L8CU"6 U_LUj JUlo

Economic Cooperation and Development (OECD), Paris. The request.wa4 __s - --- J~1 _ _ _- | L La_s:__w;Cti:> 1UJ: ... cl d 1apeU-... uUU±zIg UI± 1dC U1rD Wtll .Cil UC L;iiLiU <

countryf's debt servicing capacity..."l/ The study was presentedat the raeeting of DAC held onI January 14, 1964.

2. Tne Secretary-General of the United Nations Conference on Tradeand Development requested the assistance of the International Bankfor Reconstruction and Development on a numr.ber of topics for consi-deration at the Conference, including the "methods for relating theterms and conditions of aid to the long-term rneeds of developingcountries."2/ It was felt that this study, which is concerned withthe problems of assessing the servicing problems of developing c-un--tries, and twith the nimits of external indebtedness which these coun-tries couT.d assuwme, rill be -ermane to the deliberations of theConference on the above topic.

3. The question of limits to external indebtedness is relevantto the terms on which aid is provided to developing countries. Theterms on which aid can appropriately be provided will depend on thecircumstances of individual developing countries. Three questionsimmediately arise. First, what circumstances are relevant? Secondly,what kind of analytical assessment of these circumstances would behelpful to the decision makers when they judge what the appropriateterms of assistance should be? And thirdly, how grave should thesecircumstances, e.g., debt servicing difficulties, be and what shouldbe their origin to justify a modification in the conventional termsof international capital flows?

4. This study is conceined with the first and the second questions.It discusses the wa.rs of recognizing the circumstances which maybe considered relevant, and it also attempts to provide a concep-tual framework within which particular data and forecasts may beconveniently analyzed. The study does not make anv recommendations

I/ Resolution on the Terms and Conditions of Aid. DAC(63)10. April h. 1963.

2/ TPttpr fromr the !.eGretnr.--fPnPerql of thet United Nations Clonference onTrade and Development, dated 17th July 1963.

regarding appropriate terns of assistance. Although the study dis-cusses the debt servicing difficulties and their possible causes andmagnitude, it refrains from suggesting operational conclusions. Thestaff considered this aspect of the study outside its terms of reference.

2. Factual Background

5. Since the war international capital flows have taken a variety oilforms, ranging frcm grants and free provisicn of technical assistanceat the "soft" end to short- and medium-term loans at fairly high ratesof interest at the "hard" end. The provision of capital on soft ternshas a marked advantage for the borrowing countries as it does not giverise to debt servicing obligations. On the other hand, the capital-supplying countries find it much easier to make loans on conventionalterms, since they can be financed by savings voluntarily provided frcmprivate sources, even though temporary budgetary expenditures may beincurred where lending is done through public lending agencies. Afurther characteristic of hard loans is that they impose a certainpressure on the borrower to use the proceeds efficiently in strength-ening his econcmy, although it may be argued that the same end couldbe achieved in other ways as well, particularly in the case of adeveloping country which is likely to need a continuing net capitalinflow for a fairly long time.

6- An inevi jtnbh1 ronsequence of provision of capital on hard termsis that debt service obligaticns increase over time. It has been pro-visionally estimated that between 1956 anrl 1962 Q m-rti 7ton and interestpayments of developing countries in respect of public and publicly-guaranteed debt increased about two-nd-a-half times.l/ Given thesubstantial role of hard loans in total capital flows at present andin , the J msdate fCuture, the -proes whereb thi -ccurred is likely

to ccntinue, although not necessarily at the same rate.

7. Increases of external indebtedness and of debt service liabilitieseven when large, do not ,ecessarily imply difficu1lies for borrowers.Increases of service payments have to be measured against the strength-erning -which hlas occurred -4n the borrower's economy.~~~LLLL~~~~~~~~ WLLLt.A~~~~~~~~~~~~~~ L~~~~~d.T~~~~~~~ ~~~~JL.I.UL ± ~~~~~~~~~~~~~~~~ LA I ULi~~~~~~~~~~~~~~~ U'JJ. .1. 'JW~~~~~~~~~~~~~~~~~~~~~~%± _ LL u 4

1/ See International Development Association, The Need for an In-creased "Soft Credit" Component in Developnent Aid. This paper wascirculated to the DAC on January 3, 1963 as DAC/CA(63)4. More refined,detailed and comprehensive estimates of the recent growth of debt andof service liabilities, are given in Volume II of this study -Economic Growth and External Debt - A Statistical Presentation-,I.B.R.D. Report No. EC-122, MIarch 12, 1964.

-3-

.Theo eti caL Back; Lound

8. The basic problem in estirating debt servicing capacity is togive substance to the vague forr-.ulation ex-pressed in para. 7 above.What is m1eant by1 "strengthening of the borrower's economy"? Is thereany precise way in which this strengthlening can be measured? WShat arethe respective roles oL quantitative analysis and judgmrent in themeasurerent? To the best of our k-nowledge, no one has yet succeecded indeveloping a set of rules which will determine, in a generally acceptableTr.nner, the permissible limit of indebtedness of individuals or ofbusiness irms even in the doriestic econoi;:y. If such1 rules lhad beendeveloped, bankruptcy would already have been banished, and the job ofbankirig reduced to the cperations of punch-card rmachines or of a cor-puter. Even more controversial is thle problem of wrhat are the liritsof governmental internal borrowing or of aggregate private credit.Yany economists would say that t-he only thinr whichl matters is therelationship of total debt service to total product and that the absolutesize of either tlhe clebt or of the debt service is irrelevant. io stpeople would agree with this statem;ent, but it mst be admitted that itsoperational sienificance is lirited. The question arises; whatrelationshiip is sound and wlhen does it becoim,e excessive and dangercus?Again. i- thiere were an unaanimously acceuteCd answer to this cuestion.rmuchl of the disagree .ent with respect to proper fiscal and monetarynolici es ei tler in th-e pOrO onr in th6o rich coum tiies. would bE, nowl lhuvebeen 1-aid to rest.

9. The problemi of perm-issible lirits to external borrolwing is still7re c rrm i catec 'PHI t-,- rrln. of' t7he borVrotTi,r cnur-try catrntn iot, ri-rnt

international money in order to pay its debts; the solution to whichth debtor gzovernm mtc haeaowccsonall reortedi -in the pas.t. writh

r espect to their internal debts cannot be of 11elp in rmeeting inter-natio-,al financial obli igations. If anYt , ir + i In lationar,Nfinancing akres the fulfillimoent of external debt obli-ations T.loreSifZ i c3ul t), C a V"-l4.y OV r- thll¼ silort ru L and 1possLib c1yever the long

rmn. The borrowing country mu.st lay its hands on inteonational cui rcncyi rn ,-w-r' mb ±,^- n- i + , r] r!-,i: -

10. T?Ie transfer 1rob lenI is- one of the st controvcr.ial issues ofeconoi-c theory0 in the 1920ts, much thought was giver to tihe problemof -vrhethler thle kde '4,tol-14- cont _ _Atn 4__ acdiio to4hebreno ac1-Ai

L)l VZUuOIti.L UIU U¼~ J-,UJ.- U~AIJ UI ti -i1 CLIkZ.L ULU1A UU Ullki UU LLU,11U CZI-.U L¼. U_1tJ. ~ 6L±

domestic currency in order to neet external debt service, also faced an

exchange. Thle great discussion regarding whether a country making thetransfer inevitably e-xpAe.riences a deterioration in its term::s of -trade,

-4-

hias re_rale u /u1rui Doesvu.;z ijuUb or uudo n10 a coL11Untry uLich JJr-lakes UtJI

transfer have to sell abroad at lower prices than Would otherwiseprcvaia±9

l.. The Great Depression of the 19')30's h-es served to diroctcattention to another ver;y si,nificant aspDect of the probler.. If newcapital inflow dries up, suddenly and i,f the value of world tradecollapses in a span of a few years, considerable and wlidespDread deb-tservicing difficulties are likely to arise, and it ratters littlewh1ether this is called a transfer or a savings problen.

12. In the postwiar period, on the one hand, th-ere has been an absmnceof vioJ ent fluctuations in the imiports and capital outflows oI' indUs-trialized countries. On the o-thler, tie ,,eneral problems of econornizgrowitl-h of the developing countries have attracted considerable atteLttion.hs a result the discussion of international indebtedness has beendirected into new areas. During thae last ten years, probably the ,,ostdebated single question has been thie rate of cae,ital accu,ulationneedeci for accelerated growath of the less developed countries. Theexternal capital reqluire: ents of the developing counitries and therelated issues of adequacy of doi,estic resource mobilization and resourceuse ha-,e been the r-major issues of contemi.)crary economic tlheory andeconomic and political debate.

13. IRecent discussions of the capacity to service external debt - andof debt servicirq, difficulties which ray be called th-le pathology ofinternational capital flows - have been a naLtural extension of thediscu:,sions of capital recquirei-ents. Furthermore, the mere fact tl-atdebt service has increased as indicated in para. 6 above, has inevitablyledL to an increase in attention paid to debt servicin, problens. It wiasonly to be expected thiat; as tihe process of im,eeting capital requirlc entsevolveld, the return floxi ioula ta',le p3ace, after a tiae lag, and tlhatit would then necessarily raise a num,ber of very difficult and anal-ytic-all- inost interestinj7 questions.

1/ J.1;. Keynes, The German Transfer Problem; Th1e hteparations ?rob;emn;Views on tile Transfer Problem (2conorJ c Journal, L,arch 1929, June 1929,Sep-tenber 1929); The Preatise on '_oney, 1930. Bertil Ohlin, The Repara-tions Problem (index, Svenska Handelsbanken, April 1928); TransferDifficulties, Real and Ikilacined (Econoiric Journal, June 1929); In,er-regional ancd International Trade, 1935. lF. Terhalle, Die Theorie aesTransfers (h'irtschaftesdienst, I ai 1924). ilalter Eucken, DazUebertragu!,sproblem (Jahrbuch fuer iJationaloekononie und Itatistik,1925). Fritz Baade, Das Ue-parationsprobleii-, 3erlin 1C929. Jacqu sr-iueff, Les idees de i. .1eynes sur le problene des transfers (1,evudd'Economie Politiciue, Juillet-,aurust 192'); A Criticism (Econom-eicJourral, September 1929). Eagnar 1'urshe, internatiorale Ktapitalbewlegun-.--en. Uien 1935. This is only a snall sample of representative views inUle controversy.

. Lii;itations

14. This study does not pretendi to answer all questions. Furthermore,wre may hUve even faiLeU to raise somheof the issprvrtnmt qulestiosd The Tnda'mental difficulty is that -the theory of deb-t servicing capacity has not"yet been Iorul-uated, despite the fact that some aspects of tlhe problem.have been fairly thoroughly explored. The theory ofA capacity to se:rviceexternal debt is unlikely to be developed until the basic issues in thetheor- of economic growth have been resolved. The capaci-ty to servicedebt of ai country, just like that of a business firri, is inexorablylinked with its perforvnnce in output (sales), savings (ploughed-backearnings) and developmental returns to capital (rate of profit). Butwhile believing, rightly or wtrongly, that wre kcnowj somlethingt about thefac-tors that help explain financial success or failure of a firin, one isrmuch less certain when asked to explain why certain nations show. anarazing rate of growth ijhile others lag behind,

15. There is anotlher serious limitation which is inherent in thesubject itself. The appraisal of creditworthiness of anybody - be it anindividual, a business firm or a country - is a m.-ixture of facts andJudgments. liven if we had thle tiheory of debt servicing capacit-y, andcouild satisfactorily, explain thle likrely behavior of m.ajor variables andtheir tii,ne-path, we would sttill be facing tlle uncertainties arisinsfroma current economic and' financial policies wrhich the decision r.lersin thIE borrowing countries miaw choose to adoot. be it at tleir onrinitiative or in respons,e to all sorts of pres:sures. AnZy country, canverl quickly ret into a b.a.l.nce of nvayr-ents e -ris: i iust a f,w !wrongmolrOs in fiscal,, m-,onetary, or f'oreign exchange fielcds will suffice. .fsUc'h a criSis iS ncno.. anaied by an acourrulatinn nPf unpai d Inorn?;rciolhills or bh1 an unilateral postponem.ent of service pay, ients on long-terT. dlebt, the lender ha-s l-Ittle choice hut to stopl f-uethner lnlilTo usA: such a decision is not difficult. 'Ihat is much more difficultis t:o jul_Idge whether the policies r t;hn borrowr,rer puirsues todal are

lilkely to produce a paym-ents crisis toi.iorrow. Thie lender has to visual-1 zel n-t+ ,-tv-,H' mel,n+b- r ,.i,- ,- +r,oubIc n ar,e 1 i.ir-)y to+n ert, nd rt.only7 -loj serious they are like1,y to be, butt :lso hoW the debtor wi*llreacnit and-m -rbnt. nrinn-t. ILA .r-ll t n±.+nch ton -'l -Jill ento n-' h i rbl I-a-

tionel. :ome of these questions n.ay be answ.ered by economic analyzsLs;tne :lcestiln o- ri ori- +,; can not. The pas-t pattern o" I--ll-'i-' TI

crises ight serve as an indicator for the future, but history doesnot cl,ra'rc r.-n+at Sits-l1- T v,A4nr -i an art ard not a scincnd (nS

this art is perhaps today r,ade more difficult than ever. A banker ora governu cnt engaged in financing international econom,ic dev-lo - unthas to take into account not only whiether a balance of paym-ents crisis4,- I.i-' 4c . I ,-.c,us.4 a so ,-,d er the under-l i -n-ic- c_ 4' 1_AA

.9 -` fl . .t: U , 44 v .V 1 i-D G 0 UICUC± UliG ai:' LVIa 5 44 LII

trend in t te borrowin5 country. The problem is easy to resolve ifgove-ernient[s f±nancu±u I i±UL&t coin U I4itL -uagrnatio2 o,' tLA

econo-, or if financi-l prudence goes hand in hand with bouyanteconor;ic 5:uwth41L. But what if very h!Jighl de-velopmQental retu^ns to capitalstand side-by-side wjith serious disturbances in govern.entsl firancialaccoun u 4. ,enUind, to finŽaflce inturnaiusonJ.l economLic deUvelo-pi-int ij acontinuing oobfei4 of difficult choices.

16 Therefore, this study does not cover the following twopoints.

(a) ni continuing service ona external indebtedness denendoi not onlyon debt servicing capacity, but also cn illinness to do so.Tihe two are not unrelated, but willingness is a broader conceptresting on a combination of subjective and objective factors;it depends not only on economic circumstance, but also or.political pressures and strategy and even bargaining tact-ics.Appraisals of willingness are a matter of judgment wiich canbe discussed but for which no conclusive proof can be dei;on-strated.

(b) A country can have an iripressive record of econormic growth,arn it ma; also have good long-ran growth .;ros-cts becausedevelopm.ental -eturns to capital are hiLh even though fiecaland mionetary policies nay not be considered conduciAre tobalance of paym;.ents stabilityJ. Views will diff-er on howseverely these currert financial policies sholld be judgEd,and what weighit shlo-Ld be attachlecl to the; as oppDosed to theeconomic -rowt;h rate. This questioni of weigh;lts in cdecisionmaking is also a rmatber of Judgi.ent not subject to economicanal,ysis.

17. Lesulrs of this stud-; are inevitably circ-uscribedl by uhe weaknessof statistical series that have been used. Despite considerable advancewlhich hrs been rmade in recent years, these weaknesses still exist. 1TOW-ever, it is not believed that they impair the general findings of thestudy, although noartioular st-.tisti.e.s m-a do considerable iniustice toparticular coun-tries.

1. SJeveral choices were open in .resenting the findings of the stuldy.Thev cold e opresented i-n terms nf' t1r snvingS r nn tr2nsf'er nsrets ofdebt ;ervicing capacity. In this case, the d.istinction between short-Inci long pnri nl analys-is woul7 d be subordinated to the chief the-e, i.e.the sa.tvings and transfer pr-oblecrs. Alternati-vely, the main classitica-tion could be bas cd nn t-h -a eriodns, vhie 1 aI r-eis aml -ransf or -spectsof se-rv;icing foreign capital would provide a sub-classification..i the-r approach. hais its advantages anrd drawbackrs. ic e have cLnn en toadopt thie framewiork of period analyIsis. Within this framework, wennnlP ,+nr.t i.ritV, shortn flnrir anrrltcci anrA tfln >ro ftolf C I nine,s 1ong-

run problems or vice versa. le have adopted t-he conventional -racticeof Itrrrt-I r'.itV c nnt.-r,, -n..,lwcca aS ' Ccl ± in r -nro,rcnf+ +the icrlsequence appears to be from the long-run growth problem to t,he±nnnrrac cru7 A- -iat---- - - - - ncn - -a r 7 -- n--trru+ 1 le -rend

2

- 7 -

CHAPTER II. CONCEPTUAL FRAITEWORK

19. Debt servicing capacity of a developing country may convenientlybe discussed in terms of benefits and cost of foreign capital in theprocess of economic growth The role of foreign capital is to supple-ment national resources in raising the rate of capital formation. Bymaking nossihbl hig)her rate of inveptmpnt than wou'ld otherwise befeasible, foreign capital raises the rate of income growth.

20. Against this benefit to the national economy, there is the costof forr-ign canita.l in o-r'ms rof' n-qxrmon+. of r scrhf. srvc This nAmvzrnt

implies that the borrower country has to forego a certain amoumt of pur-chasing power, which could rl be use for "nMtion or in-vrest-ment. Debt servicing capacity depends on the ease with which a countrycan reconrcile cormpeting cl,ni-ms on its resourSes; n the o-re +.hereis the dermand for a higher standard of living, on the other there is thle

nh14-,'~±4-~ - .-- - .-4 4 - A A - .,-,1 4- 4 .-- ..14- 4 -Vn,fA 4

, fobligatior to foreiL '.n Li cS,i o AUJ UUJin a1 Ut4 .L.LtU A11j 9L.Les tuie undermini. ngI of

confidence, denial of foreign leng-term loans in the future and at theextreme, -slto rr h a,rwrdcetr rfnneadca4 r.Debtor countries have to ba:Lance what may appear to be immediate advan--tages of higher consu-mptlon and/or irivesd mern against the adverse -impact

on future econoniic growth of being isolated from international finance.

21n The problem of reconciling competing claims on resources has adifferent complexion, depencling on the time horizon under consideration.At a point of time, or in the short period, debt servicing difficultiestake the form of a liquidity crisis. Disequilibria in the balance oIpaym.ents are the heart of the matter. Whether a debtor can make bothends meet depends on the relative strength of elements of rigidity (i.E!.,the contractually fixed external obligations, minimum tolerable level ofimports) and countervailing elements of flexibility (i.e., availabilityof compensatory finance and inessential imports). It also depends on theskill of the authorities of the debtor country in managing the balance ofpavments .

22. Difficulties in transferring debt service paynents at a point oftime may result from cyclical or accidental fluctuations in exports,capital inflow and imports, or from capital flight or a bunching ofrepayment obligations. Alternatively, the liquidity crisis may be asymptom of structural weaknesses of the economy. Frequently, but notin all cases, it is a combination of purely transitory disturbances andlong-term factors.

23. In real life, debt servicing difficulties almost always manifestthemselves in liquidity crises in the balance of payments. However, athorough appraisal of creditworthiness cannot be based on short-periodanalysis only. Debt servicing capacity cannot be divorced from the generalproblem of economic growth, particularly when the main focus of attentionis a low-inccme country. Reconciliation of competing claims on resources

is easier when total resources are growing than in a stationary economy,l/A as tLe inC4Udence o'L d service ' sIo a pa_4u U! Auie >incremCnLt-UU

in per capita income, it is possible for consumption and nationally financed"Iv4Ai to1IWI1U r LIse pu-i pasb,5u Wi 11 service payJiieiU11 n iiU iI hle raue ofincrease in real income and savings, remaining available after the claimsof foreign capital have been met, is reasonably nigh, if growth occurs ina continuous fashion, and if its benefits are widespread, it can plausiblybe argued that debt service payments will also be made smoothlys.i in thiscase, the opportunity cost of fulfilling external obligations is lessobvic-us and presumably less burdensome, than in a situation in which servicepayments impinge on existing living standards and employment levels. There-fore, it can be argued - and this is the fundamental judgment or whichthis study rests - that continuing growth in per capita production ancd theunderlying process of rapid accumulation of productive capital is the basiclong-run condition of debt servicing capacity.

2h. The main task of long-run analysis is to define the conditions underwhich the economic growth process, which is partly financed by foreigncapital borrowed on conventic,nal fixed terms, can succeed; and which canthus provide a basis for continuing servicing of external debt, and, ifnecessary, for its ultimate retirement. Relationships between severalcrucial variables - return on capital, savings, investment, growth ofoutput, required foreign capital inflow and the associated cycles of debtand of debt service ratios -- should be formulated and their time-pathsfollowecl. Values for the variables can then be chosen on the basis ofavailable evidence and the implications of such choices explored. Jhatare the conditions for a successful outcome of the growth-cum-debt processwithin the life of one generation?

25. Since national econoriic growth occurs in the framework of the worldeconomy and since we are concerned with debt service obligations to ex--ternal creditors, the discussion cannot be limited to domestic variablesonly. For growth to materialize, it is not iufficient just to raise therates of savings and investment. The pattern of resource use must be suchas to lecl to a reasonably competitive production of internatirnal goods,i.e. products that can enter exports at remunerative prices or that canrplace iin.ortr.

26. This is the conceptual frnmrork-.1l withiin w - Thich riaht. se-ricing capraciiitT

can be appraised. The main problemi is to develop a method of analysis forassessing li uidiy anrd elements relevant to long-term growth. This paper

is an attempt in this direction.

1/ This± was~ theC basis of Uthe grouw,,-cuni--,nueuueudes iuci UrrdVld UvlpU in

1953 by 1Hr. Gerald M. Alter of the Bank staff. The study was publish&.n1 1976, tiuer tihe UtLite Ie ServicIng of Foreign Capital Inflow by Under-

developed Countries, in: Economic Development for Latin America, Proceedings;International EconoUMIc AssociaTion, New York, i961.

2/ Thiq TwTas t.hn mordel doeelonnnpe in the anlr in 101eA and imnlici+. in n dt.yr1xrthat was published in 1958 (Dragoslav Avramovic, Debt Servicing Capacity andPo stwar- PGzowthP n I t. onal In 0±A ± s Pe,J 1 )

Cy-)

- 9 -

CHAPIER III. THE LIQUIDITY lSPECT OF DEBT SERVICING CAPACITY

1. Variables

27. The Dresent chaDter considers methods of Judging the size andgravity of the payments problem which debtor countries may encounterif their external reeeipts sudldenlv fall; while they have to maintaintheir fixed, contractual service instalments.4/ From the point of viewof the present. chantepr. rtlp1-. qP-mrivn- ng dHiffircmlt.ies are one element.among others in the general picture of balance of payments vulnera-hilityv The discussion thus moves closely parallel to a discussionof, e.g., the adequacy of reserves, but with special attention to debtservi 14 lkiabilte as ai specia nelement of rigdt in +the situatiorn.

28. The fa-tors which -fTect the balance of pay--onts and hencea country's capacity to service debt in the short- and medium-termcanI be c"lassified as.,

-L. IF] var ab'es

aI) exLportls(b) capital flows(c) emergency adlu in'I' atiUon-induced importUs

c. Cfetting -variables

ka) reserves:(b) compensatory finance(c) comapressIOle Imports

3. Rigid variables

(a) minimum tolerable imports(b) debt service - interest(c) debt service - amortization

29. Economic policy of the borro-ing country affects the behaviorof all these variables in a crucial manner. In particular the balanceof payments situation may be seriously aggravated ifi domestic fiscaland monetary policies are not adequately managed.

30. The process of economic growth is one of profound economicchange. This change affects, among other things, the behavior ofthe variables enumerated above. Some of them assume greater flexi-bility while others tend towards rigidity. These changes, in turn,influence the way an economy responds to a liquidity crisis.

1/ The actual experience in the cyclical downturn of 1957-1958 wasanalyzed in: Dragoslav Avramovic and Ravi Gulhati, Debt ServicilagProblems of Low-Income Countries 1956-1958, Johns Hoopkins Press,I76T9-

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2. Fluctuating Variables (Disturbance Variables)

(a) Export declines

31. A major element of balance of payments vulnTerability of manydeveloping countries arises from instability of export earnings.Short-term declines in export earnings have in the past oricinatedlargely in cyclical declines in international demand. In addition,there have been falls in export receipts caused by occasional naturalfailures in supplv. Further. a number of developing countries haveexperienced reduced earnings over the medium-term, originating inexcess nroduction of nrimarv products in relation to demand. Finally.export cleclines may be caused by domestic policies which adverselyaffect the incentives to produce for P-znortq or to sell on the. inter-national mnarket.

32. The first and obvious approach to the question of the possiblefiut-urp severi ty 1n l-nreth.i ocf periodis of depressed 0v-rnrt. earnincgs is

to look at the behavior of aggregate export earnings in the past.Howvr-1T1 r an overridinhpoblemis i he shrntness of the nr,riod- fromn

which it seems relevant to draw conclusions for the future, Historybefore 119J9 -is no lonE;er very ilmntn.The aboraite of th

war and immediate postwar years were immediately followed by the furtherCUt ly ij CLCi_ AjJCI C1 C '4± UIIC i11U± d.IL1 U'4IIULUUU±UY . UL"JtI I ±I I Cl. I J Cz L~~, ~. .u~

fruitful to consider the behavior of exports over the last decade or so,and in so short a period, few countries may have '.*e as greata short-term fall of export earnings as may occur in the future.

33. Another question arises of how to nêasure declines in exporteanLings, -hether from the 1;rend or from the preceding high point.Deviations from a dowJnward trend show the fall from an average. However,this conceals the fuli impact of the decline, counting from the peakto the trough. If a country experiences a persistent contraction ofits exports over a number of years, it will be in a difficulb situation,even though the percentage of the yearly decline may appear quite small.

34. In countries where export receipts fluctuate over a relativelyshort period, if the government of a country concducts an anti-cyclicalpolicy andl has perfect foresight, it may take advantage of a period ofabove trend exports to builci up reserves, and pay off short-term debts.,and would thus be prepared to face a period of below trend exports.In such cases it would be justifiable to think in terms of declinefrom the t-rend. However, this policy behavior is not evident in mostunderdeveLoped countries. E'eriods of above trend exports are alsoperiods of high consumption and investment expenditure and there islittle set aside for a period of below trend exports. In such casesand in cas,e of countries experiencing fluctuations over the medium-term,a measure of decline in export earnings based on maximum decline from El

peak woulcd portray the situation more accurately than would a measurebased on clecline from a trend.

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35, Table 1 shows relative amplitudes and duratihn of maxim-.i declinein export, earnings, measured from a peak. Table 2 shows relative ampli-tuides and duration-s of pder_od-c of lowJ ex-sort ear,-,+ from a lin-a

trend of exports.

Table 1: Recent Short-Term Eport Declines, From Peak to Trouwhand Corlmo itr Concentration of Ex-nrts

Share of Two PrincipalPercentage Period of Commodities in

Country Decline Decline Total Exports

Uruguay 54 1956-59 77Bolivia 38 1956-58 60Sudan 35 1956-58 62Turkey 28 1957-58 42Colombia 27 1956-61 86Pakistan 25 195g-58 64Thailand 22 1957-58 57Nicara'gla 22 1955-58 58Ethiopia 21 1957-58 64Dominic an

Republic 19 1957-59 63Brazil 18 1956-62 60El Salvador 18 1957-59 74Costa Rica 16 1958-59 76Honduras 14 1956-59 63Ecuador 13 1960-61 77Argentina 11 1960-61 70Philippines 11 1958-60 52Taiwan 4 1955-56 49Spain 2 1959-60 25Venezuela 2 1957-58 91

Source: Internationel flonetaryr Fund, Interns tional Financial Statistics,various is.ues.

Table 2: Maximum Percentage Short-FaiSThof "IIerchandise xCport Iarning,s from Export Trends1to L years cumuiIat:ve) and Commodity Concentra-tion of :Exports

Mlaximum Percentage Short-FalLs Share of TVc,Below Trend Principal Gom-

one 2 years 3 years 7 years 2, / moities inyear cumulative cumulatiLve curmulat ive Total Exports

Uruguay 34 23 21 19 Venezuela 91Sudan 26 1.7 8 7 Colombia 86,Turkey 23 8 7 5 Uruguay 77Bolivia 22 1.3 12 9 Ecuador 77Thailand 18 1L1 9 4 Costa Rica 76Pakistan 16 ]4 10 8 El Salvador 74Spain 15 1.3 10 7 Argentina 70Costa Rica 15 5 2 2 Eth.iopia 6)4Dominican Republic 15 10 1 2 Pak:istan 64Honduras 15 j 6 L 2 Dominican Republic 63Nicaragua 15 1]2 9 7 Honduras 63Ethiopia 12 11 7 5 Sudan 62Argentina 11 6 4 3 Bolivia 60Colimbia 9 6 5 4 Brazil 60Ecuador 9 5 1 - Nicaragua 58Taiwan (China) 9 7 5 3 Tha:iland 57'Brazil 8 6 5 3 Philippines 52Venezuela 8 1/ 4 1 1 China 49Philippines 8 4 2 1 Turkey 42El Salvador 6 5 5 4 Spain 25

Mote: Maximum cumulative short,-falls were computed for consecutive 2, 3 or 4 years. Thus actual exportsmay not have! fallen below the trend line for aLl tne years cons.idered.

1/ :L955 included.'L/ :L962 included.

S-c,urciab: !eruhandisu cae. f ports from .' 1562s 3ssu; c 'vrdrond C1 omp:uted.

from, data. from. 1-555~ through 1-962. Pricd coErerd,, 19,55-:L96'2,,

- I1' -

36. For an assessment of how far fluctuations in export earningsare related to the commolity concenLration of exnorts, t-h tablesalso show for each country the latter. It cannot be expected thatthe size of fluctuat.ions of exrn t earnin- s *r-1 evervw7herebecor-

relatecl with the degree of commodity concentration. For instance,variantionns in eprt- eani+ .-,

1- _=,baosed --econo - -.r 11 be

small as long as the world petroleum prices remain stable. It isnecessary to consider not only LI .howj 4± ated a cuntry±s

exports are, but on what commodities, and how supply, demand andprice o' these t-part-cular comnodities are apt to beh[ave. But f

the primary producing countries as a group, there is a tendencyfor export erinsto -lcuae ald 4to -_,4--4ate --ioentlyL'-J ~.JpU U _ III.Ltr ~A) ±..LUU ULLLACAL, c1,1U LA .) -LLU ;UCLA±U V.V±u±eIiU_L,Y

3 7 hln exa Uple of medi-UUUerIL texpUorU UtcUli11e is pviteU Uy Ulth

postwai development in the export earnings of the countries dependingon cofI'ee Uhe second largest commodity, after petroicein, moving ininternational trade. The fortunes of the world coffee market decisivelyuetermline Wie ilow oi ex)ort income, and thus tLhe capaciby uu importof some dozen countries in the tropical belt, including half of LatinAmerica and a large part of Africa. The latest coffee cycie startedearly after the war, wh'en supply was short and demand was recovering.The price of coffee rose sharply from the disastrously low level thethad prevailed in the preceding two decades. Since there is a time lagbetweenl investment and output, supply iagged behind. 'The period ofrising prices lasted until 1954, and then, as supplies caught up withand overtook demand, prices began to decline. For the last eight years,earnings from production and exports of coffee have been falling year-in year-out. in 1962, the value of world coffee exports amounted toQl.7 billion, compared to the postwar peak of .½2.5 billion, in 195 4 ,The tra-ic paradox of primary products economies is exemplified by thefact that the coffee countries prcduced and sold in 1962 a quantitywhich-i was 50 per cent greater than in 1954; and yet, their exchangeearnings in 1962 were one-third smaller than eight years earlier. T'hecumnulative loss of real income and foreign exchange sustained by theproducing countries duriig these eight years was enormous, whicheverway you measure it. The persistent pressures on their balances ofpayments led to severe strains on internal finances and inevitablyhad an adverse impact on the rate of capital formation andl economicgroath. The complete breakdown of the balances of payments was pre--vented only by the decision ofr the leading producing countries towithhold some of the excess supplies from the market. Tab'le 3 on thefollowing page shows world exports of coffee, by value, from 1950 to19620 The data for 1963 are not yet available; over the last twelvemonths, coffee prices have recovered somewhat. It is not yet clearwhether the recovery will continue or the prices will level off.

Tab2, In Coffee: World Export Values(in millions of US $)

Other LatinBraAil America Africa Others Wcrld

195( 850 568 162 15 1,5951951 1, 039 666 240 28 1,981195' 1,C26 745 208 23 2,002.1953 1,C090 915 386 59 2,450

19514 948 1,0142 476 74 2,540

1955 844 957 349 30 2,1801956 1.030 923 393 64 2,h101957 846 945 424 75 2,2901958 688 862 378 72 2.0001959 774 766 374 46 1,9601960 713 730 359 )10 1.8b21961 710 671 317 52 1,7501962 __4 7143 (2H5) (So) Th721.~

/ PreliminarySources: International Coffee Study Group, Pan American Coffee Bureau, IBRD

Economic Department.

_Se 3a: Export Indices, Quantity and Value, forCoffee and Major Commodity Groups

(Base: 1950 - 100)

Coffee_/ Primary Commodities i1 Manufactured Goods-/(quantity) (value) (quantity) (value) (quantity) (value)

1950 100 100 100 100 100 1001951 109 124 104 126 120 1441952 110 120 102 108 119 11441953 119 154 108 109 127 147

1954 99 159 112 119 132 149

1955 115 137 121 122 146 1681956 131 151 131 134 161 1931957 123 144 138 142 171 2T'1958 125 125 135 131 169 2,61959 144 123 1144 135 183 2211960 147 115 155 146 207 2551961 149 11Ci/ 164 151 213 2641962 156 10821 n.a. n.a. 225 284

n.a,. Not available.a/ Coffee figures cover the World; primarv commodities' figures and manufactured

goods' figures exclude the Soviet Bloc.b/ Preliminary.Source: Various issues of the United Nations Statistical Bulletin & of the Yearbod

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38. How f'ar does the experience of the past provide a guidance tn thefuture' The problem of medium-term supply-induced fluctuations stillexists in all its intensity, and it is unlikely to be solved until asubstarntial advance is made in the diversil'ication of the production andexoort structure of countries heavily denendent on products experiencingmedium--term production cycles. Also, falls in exports caused by break-doirms of sunnl arp likelv to c.ontiniie. Similarlv. unless devrloningcountries' policies differ from the past, there will continue to be casesof exp-ort declirnes resultinj fron measures havin A restrictivP effect onexport sales. On the other hand, violent business fluctuations, sosignifican+ in the prewar neriod, are not likely to recurr._/ Consequentlythe intensity and duration of demand-induced declines of export earningsTwill mo,s+ likelyloe Iess than th-y uaed to be. This does not mean how-

ever, that the problem has been solved. Considerable fluctuations stillAotnue. So far, on-ly r.oeaeavnc a enmdei tblzncon -LIY~ li L± UELLY UL~'UU1 '-', UtV- IU I_ iI _L4 I

world commodity markets.

39. In the context of the long-term relationship of various factors inthe growth process, it i;s suggested in Tchapter V that in a numlber of'developing countries exports are likely to grow at a slower pace thanincome and inUvestmf1entU. Ats a result, there is a tendency for imports tobe concentrated increasingly on the most essential items. NAso, demand foruiprb3)o *s very strong as a resuLt oI income groawt targehs. Ihls 1i

further intensified by excessively expanzionist domestic monetary policies.Thus, although export fluctuations nowi may be less intense by themsieives,they occur in a situation in which the balances of payments of thedeveloping countries are already fairly strained.

(b) Swing,,s in capital flows

4o. iV,riting in 1927 of international canital flows, T. l. Taussigdescribed the ebb and tide of capital flows in these words:2/

"In fact, however, the loans from the creditor country, so farfrom bein'- made at the same rate year by year, begin with modestamounts, then increase, and proceed crescendo. They are likely tobe made in exceptionally larger amounts towTard the culminatingstage of a period of activity and speculative upswing, and duringthat stage become larger f'rom mlonth to month so long as the upswsingcontinues. 1.!ith the advent of a crisis, they are at once cutdown sharply, even cease entirely. 'The interest payments on theold loans thiereupon are no longer offset by any new loans; theybecome instantly a net charge to be met by the borrowing country.A sudden reversal takes place in the debtor country's internationalbalance sheet; it feels the consequences abruptly, in an immediateneed of increased remittances to the creditor country, in a strain onits banks, high rates of discount, falling prices. And this trainof events may ensue not once only, but two or three times insuccession. After the first crisis and the first overturn thedebtor country is likely to recover. 11Tithin a few years loansfrom the creditor country may be resumed, another period of activityand speculative investment set in. the old round repeated, until

/ at least, IBRD, IDA and IFC operations are based on the assumption that theywill not recur. (ITTDT l7orld Bank, IFC and IDTA Policies and Oeratic:ns

April 1L962.)> / v- LLT 'P 4 L- L TAQern A. . Jn TP.. T 2. AJV.f1, -17 Q * I4 . 4-L -4 LIQ.. J 1. -',':. 11. u S-g TritL I 4 t- . 1D 1L SW.t l tWon 1U1 L V1L An , - / L. J J. -L |Ii L~, _OL{/ L; -LI

- 16 -final'y another crisis -or -another sudden overturn in thebalance of international payments. The final outcome, when this-long pe-io' of firreg-U ar mo-vementI-s h1as run. it-score tath±UL tLLU Lu ±1 .L l .UL

debtor country has more to remit on interest account than toreceive on pr-neipal account, and that the remittance iseffected by an excess of rmierchandise exports over imports.Te 11-ist-ory of the Unted 4+ Stages and ofP Arg-entina both, of' wichq

were typical borrowing countries at similar stages in theireconomjlc deve lopment, show - -- _cs ve r '. oit.tional borrowings, repeated crises, deviations from the simpli-.L fLe. process set fUort iULi JLII 1I -- eU-- -----

41. histor-y of international capi tal flows up to tle Second WJorld Wlrsuggests two important characteristics of such flows. First, a consid-erable proportion of capital infiow into developing countries wasspeculative in nature. Private investors in the major capital marketswere not always aware of conditions in distant lands and invested innumerous ventures which did not have a sound basis. Secondly, thesecapital flows were extremely sensitive to the ups and downs of thebusiness cycle. During a recession, the liquidity problem was furtheraggravated by cessation or even the reversal of capital flows.

42. The flow of foreign capital into developing countries presents adifferent picture today. Private direct investment abroad isbased on much more information than in the earlier periods, and invest-ment decisions are much better prepared. National and internationallending agencies are now large suppliers of foreign investible fundsand these are lent mainly for productive purposes.J While dow,nwardswings in capital inflow into individual developing countries have notbeen absent in the postwar period, by and large such capital inflowshave tended to compensate for declines in export receipts or, at aminimum, they have maintained a fairly stable trend in the majorityof countries.

43. It is true by definition that a country would have no debt servicingproblem if capital inflow were alwavs sufficient to allow it to meetits debt servicing obligations wdhile at the same time maintaining importsat a level which the country considers minimum acceptable. However,despite the stability in the aggregate flow of capital recorded thusfar, for the great majority of countries it is not in present circum-stances possible to forecast for a longer period the prospective levelsand fluctuations of canital imports annd the rangn nf terms on which thcjvwill be available.

h4. There are, however, some forms of capital inflow on which a devel-oainfl r-olint.rv y.cn rolTAn th n fnir di zcr-rp rf' nccmrrnnn- ::+. -qnr r+T f'cr

the near future. For example, disbursements on project loans willcontinue so long as work on the project goes forward and any otherconditions of the loan are complied with. Suppliersl credits are usuallya-vailabl urnless Jthe p'. r is cosdee -to be V vr svr balarce

of payments difficulties; but the terms may become progressively disadvan-tageous~~~+-, as-A-4 -the _-udiv cisaproach-es. Onth ohe hd

Excludecd from consideration in this study are resource flows which arenot directed to financing economic development.

- 17 -

private direct investment will necessarily tend to fluctuate in response tochanging conditions in both the capital importing and the capital exportingcountries. But since a considerable fraction of foreign private capital indeveloping countries is now invested in manufacturing for the domestic market,this will exercise a stabilizing influernce. The domestic markets for ralu-factures in the developing countries tend to expand at a rapid and fairlysteady pace whenever the overall grvwth rate is satisfactory. Above all,investment loans from international agencies are not sensitive to short-runfluctuations in the balances of payments. Loans and grants provided by g-vern-ments in the capital exporting countries behave in an anticyclical fashion.But there are other causes of instability in government-to-government flows,largely political in nature.

45. The preceding paragraphs have dealt with possible downswings in theinflow of foreign capital. Yet another source of disturbance, which can be ofgreat importance in some countries in particular periods, is sudden outwardmovement of domestic capital. This phenomenon is caused by a numnber of factors3primarily of political and monetary nature. Countries which have experiencedbursts of inflation and successive devaluations would be particularly exposedto capital flight. Despite the fact that these perverse capital movements fromthe less develoned countries to the neveloned ones have been frequent. verylittle is known about their magnitude. But it is highly likely that this out-ward flow has heen ihstn±.il and th-t. the asets hed nbhroad qre very large.This potential source of finance of capital formation in the developing coun-tries has not yet heen tapped. Some wayt ought to be foulnd to minimize furthercapital outflows and to attract these funds to finance national economic growth.

(c) Emergency or Inflation-induced Import Increases

46. Periodic increases of imports may be destabilizing to the balance ofpaj.nts. Suc ' vaa.tions ma0y De ca~used by a *uMWErl of faVctors

h7. Crop failures and bad harvts ,may lto s f increase in theimport of f'ood and other agricultural commodities. TJhile, in terms of thedomestic cons-u,,ption of these coSi iuTodtLies, these increased ,imports may bemarginal, in the balance of payments they may lead to large swings. And suchiDsV-Lllr.s hIavet:;u:ii bee I nJJJ I.,dIiL., ±da'tuL ue o.L Uthe Ud.lcuneU L ofpyJ,LtjiLs ; of a I1U1i1LJU

of developing countries during the postwar period.

48. Public Law 480 of the United States Congress authorizes the sale ofsurplus agricultural commodities in exchange for locai currencies of theimporting country and, in certain cases, for outright grants. Supply of' agri-cultural commodities under tnis law has, in effect, provided an insuranceagainst balance of payments crises induced by bad harvests. It is an importantform of compensatory financing and a partial substitute for reserves of foreignexchange and gold. Had the U.S. agricultural supplies not been available tomany developing countries on easy terms, the balances of payments of thesecountries would have been much more strained than was actually the case.Furthermore, their whole growth process would have been seriously undermined.

49. Another important source of temporary import increases ray bedor.estic inflation, within the framework of pegged exchange rates. Thishas been a familiar anr fairly wiidespread phenomenon in the developingcountries during the last two decades.

50. TILere is little indication that these causes of imiport increaseswill not recur in the future. Agricultural production has in many develop-ing countries lagged behind dor.estic denand which has risen rapidly inresponse to growth in incomie and in certain cases as a result of subsi-dized food prices. Consequently, the frecluency and magnitude of importincreases mi.ay well becorm.e greater in the future unless measures are tal:ento increase dom.estic ouitput by applying as rrodern and efficient n.ethods ofproduction as poscible. Similarly, although there is an increasingawareness in the developing; countries of the consequences of inflationaryfinr.nce, it would be too optimistic to expect that inflationary pressureswill not recur. It is becoming increasingly recognized, however, thatfixed exchange rates in the face of continuing inflation are bound togive rise to excessive imports, and therefore flexible exchange ratepractices L.ay have to be a-Pplied. Lven if some such mechanisrm is used.it is nmlikely to work efficiently unless the rate of cloy:estic monetaryexpansion is kent within limits. Also. unless flight oL' cb-it1 abiroadis reduced (para. 45), tlhis by itself would greatly disturb the foreignexchange inarkets

3. 0ffsettiir' Va:iables (C1ir-nenPsat7nn VJariables

(a) ? 'xtprnpl reserves.

51= Dulring the nostwar -year , use ofn foreign exchang an bold res veshas been one oL the ways of adjusting to a period of depressed exportePa rniIc. r n ci ..ports..c n -n--',., c 1 vr o u--Y-+ o -11 i +

of their adequacy iv the ratio of reserves to the value o- a year'simp?orts. Ideally these ratios should be net f GShort - ter claim-s. Inpractice such an attem,pt frequently runs into many statistical difficulties,

52. Reserves coLmp)rise gross official gold holdings, convertible foreignexchanre and the country's gold tran chee pos it-i on + t tth,-e c-.. A.$ dE:, -L~S~ C>I±2 J~± W~ UL U11 .1 *j~ Id) "efi rJi U"

present reserves are shown, expressed as a percentage of current irrmports,2. w '-4 s 1-2. 12 UJli UL Ui LU iItUILt U±LICI.L , { , U1 .j

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Table 4: Conditioral and Unconditional Liquidity as a Percentage oI Imports

Unconditional ConditionalCCountry Liquidi- 1/ Country Liquidity 2

T'hailand 100 Bolivia 27Malaya 94 :3/ Afghanistan 26Israel 86 Pakistan 25Burma 77 India 24Ethiopia 72 Mexico 20

Spain 66 Ethiopia 18Sudan 64 Brazil 17China 61 Burma 17Nigeria 60 ij/ Honduras 15Jordan 57 -- Morocco 15

Ghana 52 Argentina LbAfghanistan 47 5 Ceylon 13Pakistan 45 Iran 13Mexico 39 Costa Rica 12El Salvador 38 Ecuador 12

liorocco 37 ]Nficaragua 12Nicaragua 37 Spain 12Tran 36 Turlkev 12Ecuador 34 El Salvador 11Tm-rkey 30 Gha~na 11

Ceylo~n 29 ITiG 11Tunisia 29 Phi' ipiines 11UAtR 29 Yugoslavia 11Korea 27 Chile 10InTA 26 T ailand 10 1 n/

P1eru 2U,bl8Colombia 20 Jordan 8H onduras 20 Peru 8Costa Rica 17 Sudmn 7Chie 15 IIIsrael

Argentina 12 UAR 3Braz'l1 /Gll ,/Bolivia 8 Ivory Coast Y

-- -,, _ A IreA 7

P ~~~~~~~~~~~ ~~7/Ivor-y CoasSLeSenegal V TanganyikaTanganyika j goTogo / Tunisia 7/

See footnotes next page.

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Footnotes to Table )4: Conditional and Unconditional Liquidity as a Percentageof Imports

J *Monetary Reserves and DT G LdTrnancbe Position as%ofd in, ie., grossofficial gold,convertible foreign exchange reserves and the country's goldtranche position with the fliF (generally as of June 1963) as a proportionof imports, c.i.f. for 19620 Reserves are gross in the sense that no al-lowance is made for short-term liabilities. Reserves of non-official enti-ties are not taken into account. DIF gold tranche position is added to thecountryfs reserves on the theory that drawings wiithin the gold tranche arealmost automatic. It is not possible to segregate non-convertible reservesin many countries0

'Unutilized lDY Credit Facilities as % of Importso in addition to limitationson the amourits which the IMF can permit to be drawn in any given year withoutwaiver, there is an over-all limit of 200 per cent of quota on the amount of-any memberts currency which the Fund can hold without a waiver. In February1963, the DIF decided to provide a drawing facility, normally up to 25 percent of quota, to compensate ter,,orary short falls in total export receiptsof primary producing countries. The Fund has stated its willingness to waivethe limit on Fund holdings of 200 per cent of quota, where appropriate, toimplement this recent decision. The new facility can be regarded as increas-ing pro tanto the total amount that can normally be drawin under suitablecircunstances. The calculation of "unutilized DIF credit facilities" hasbeen made on the basis that holdings can rise to 225 per cent of quota.Existing currency holdings and the gold tranche position are subtracted from225 per cent, of quota. This is a partial measure of discretionary compensa-tory finance available under specified conditions. These conditions becomeprogressively rigorous for transactions in successivelv higher tranches. Itis a partial measure because it does not take account of borrowing fromforeign commmercial banks and bilateral public sources of compensatory finance"possible for some countries.

3j This computation refers to the old Federation of Malaya as distinct from -thepresent Federation of Malaysia. We have assumed that 65 per cent of the mone-tary reserves of the Currency 'Board belong to the Federation of Malaya.

UV.ld arld Foreign Fxchange Reserves at Marcht 1961 ard Imports 160

Source: IBRD Report.

5/ Source: IBRD Report.

M Participant in currency arrangement involving pooled reserves.

l Subscription to fIF not yet complete0

01 E .xcluding gold pledged to foreign commercial bank s.

Q/ a- ocr-irig-n-llr est+.blshed for all China iee. including the I4ainland,

10/ Thailand is exempted from the general reauirement that an initial par valutebe established before drawing on IMF, Irawings are permitted under condi--t,ions deterinined b'- RIE. The airsed orlm 3oinitj_na valve is used in thesetransactiOns,

- 21 -

53. Tw' fundaimental changes in the level and complexion of reserveshave taken placd in the postwar period. First, with emphasis oneconomic development and growing need for investible resources, theopportunity cost of maintaining foreign currency and gold reserves hasrisen. A number of countries have partly run dowin such reserves forfinancing economic development. while others have spent their reserveson excessive imports caused by inflationary pressures. Secondly, provi,3ionof' liauidity through the International HIonetary Fund has to a certain e -tentreduced the need to maintain large reserves of gold -nd convertible foreigncurrency. TLhe lack of flexiThility introduced bv the first develonmeint, hasbeen partly compelnsated by the second.

54. Like other variables discussed here a countryts olmn reserves bythnm'selvcs are not a complete indicator of a country's abilty to weathEra liquidity crisis. Specifically, in this context one has to consider thecompensatory finance available from international agencies anc privatesources. This is discussed below.

(b) Compensatory finance

55. The operations of the International Monetary Fund have been ofgreat irpor tance in assisting; developing count-r4e to cp wlth t:eUl

balance of payment disequilibria. Recently, the Fund introduced a newco-m,ensatoryfc y to ofPfset fLluUctuaLU ion in eôt a-ningsTable L, (Conditicnal Liquidity), shows the scope of potential IITFoperations, cal'culaed Ofi the basis tha ra' d U oidin-s of couanr-,currencies cannot exceed 225% of quota. Such drawings are conditionaland require substantial justification, tlhe conditions becomiing- increasing-1y stringent the greater the existing dra-wings in relation to quota.

56. The most important source of compensatory finance in some casessince the w-a- has been lending by public agencies in the developedcountries, particularly the United States. This balance of paymentssupport has been provided bothi to offset short-run difficulties and tomeet situations where depressed earnings have lasted loncer (see paras.31 and 37).

57, Another form of compensatory financing is snort-term borrowing inthe private market. Such borrowing facilities were readily availableup to 1929 to many coun-tries in balance of payments difficulties. Short-term capi-tal movement between developed countries has, of late, reappearedas a device of adjusting to short-term fluctuations in the balance ofpayments. Am,ong the developing countries, the case of a developingcountry is known which has on several occasions, during the postwar period,succeeded in borrowing from the private market to weather temporarydifficult:ies.

58. Compensatory financing is an effective substitute for the maintenanceof large reserves of gold and foreign exchange. As a general rule,countries which enjoy close and harmonious rclations ;with the majorfinancial cfnters may be regarded as having a second line of reserves.Although the drawing facilities provided by the International MonetaryFLnd are a definite advance inI the provision of greater liquidity, most

developing countries do not at present have ready access to the private short-term capital market.

59. The flow of short-term pri7vate capital from Uevelopeu Lo developingcountries has had two features. First, in many cases it has flowed from adeveloped country to a present or a former dependent territory, largely throuVghthe branches of the developed countries' financial institutions. Theseinstitutions have during the course of time built up an expertise in suchtransactions. Secondly, where such conditions did not prevail, lenders chargeda high premium for risk. Such lending, in effect, added to the possible futurethreats to liquidity. And when compensatory finance, whether from this orfrom other sources, has been contracted on short term, while the export declineslater proved to last a number of years (e.g., para. 37), an overhang of debtwith short maturities was created. This overhang is today the major threatto liquidity in a number of very important developing countries.

(c) Compressible Imports

6G. The comnpressible part of the import bill serves as an offsettingvariable. It has not been possible in this study to classify uniformly theimports in order of their comiressibility. Which imports can be reduced?This depends largely on the pattern of production and demand in each country.Scme countries may nroduce most of their manufactured consumer goodsdomestically 'but import food and raw materials. Others may be largely self-sufficient in food and some raw materials but imnort consumer goods. Can theimports of the latter be regarded as compressible and not those of the former?And how much hardshinp is a gonvprnm.nt ble annd nrpnared to ipmose on thepopulation? These questions have yet to be answered. The historical approachwould require the study of a ny correlation that may have ex-sted in the pastbetween fluctuations in external receipts and in imports - either concurrentlyor with a time l n. Furthemore, an investit nion wTill hn-av ton 'h T__ nio thle

patterns of import reductions in times of difficulty and whether these patternstend to change in the process Of ccw.-oic developrment Judg,.ent coul ci thpel

be made as to whether the imporit policy in the future would be similar orA.; .f "I eren'

4-1 A .. h;n4;ca+or wbh; h mt- hQ- -l¢A +>; nA-; ,ofo +11a Aesarrp of

compressibili-ty is the proportion of' consumption goods, other than food, into4tal 4i.pports. Ile assu,,ption - not yet con4-irmed = st atevlopl_~ng

"U -dL -IijL t UJ ±L a UIk L A.-L LL U v U l-It'I -

countries would rather cut down on this item, at least over the short term,4.h-L p J .' 2 . P C' A - -. _-I. P,-$1~~.~tlhan resor'tLU to a red-uctVULt of U.-t of fLoU, raW mtials, fls acapital equipmaent. Table 5 summarizes this information for a sample ofcountries.

- 23 -

Table 5: hP_ors l'f Non-Food Consumier Goods, 1961

(selected countries)

As % oftotal

merchandise

1961

Honduras 35ThaIlad 31Ethiopia 29Ecuad or 20Costa Rica 27

Nicaragua 25v -I o, 11 L _El Salvauor 5)Venezuela 25lionlinicarn Republic 25Sudan 24

Bolivia 21Colombia 18Uruguay 16Turkey 12Argentina 12

Philippines 12Pakistan 9Brazil 6Spain 6

Source: Imports (c.i.f.) data: IMF, InternationalFinancial Statistics.Imports of non-food consumer goods: U.N. Year-book of International Trade Statistics; countrytsown trade statistics; OEEC Foreign Trade byCommodities (exports), Supplement January-December1961; and FAO Yearbook nf Forest Products Statistics19620

- 24 -

62. It may be argued that the process of economic development tends tointroduce an element of rigiclity in the import structure of developingcountries. Expansion of the industrial base reqpires expanded imports offuels, raw materials and capital goods. Reduced imports of these goods maycause unemployment and affect; the momentum of growth. Peduced imports ofstaple foocds is rendered extremely difficult; imported food, in most cases,serves to supplement local supplies to urban centers whose population hlsgrown rapidly in the postwar period. Experience suggests that there aresevere limitations to the possibilities of reducing food supplies to thesecenters.

. Rigid Variables

(a) "Minimum tolerable" level of imnorts

63. The preceding analysis has touched on various aspects of theinflexibility of' the import structure. lthat degree of inf'exibility willbe poresent in narticular casFs wil denend not onlv on the shane and Datternof develop-ent, ut also on t,he de,ree of rigidity with which income growthtargets are? niirrmpr-. WT` le th ftct.ors 1 wi n I een rilv vary from eaqP

to case, an insight into their effects would be obtained if a detailedanalysls wTras made of the patterns of adjustment of particular countries todeclines in the capacity to imports (see para. 60). It is in deciding the

nom-oSi -ion ofr r inim.iim reqiiiypred iyv't irts q tha+ oens encunte

most serious problems of choice.

(b) Debt ervice - inrerest

64. Interest on foreign debt is the most rigid element of a country'sbala-Lance of y payments. Interest is contract faxe ad is a recurringcharge on the economy regardless of the borro,Ter's fortunes. Fixed-interestueub Lli mIios., UQUco-itr:ie;b UUIADs toUUJ .Laet Vi jULPUL."L adlu PUUiLL-±,

guaranteed debt. Consequently, any failure to pay this recurring chargeaduversely- reflects orn a foverrunent' s abilit,y to save aniu tU Lra-l5eri

savings, and thus inevitably undermines its credit standing.

65. The question arises wlhether service on public and publicly-guaranteed_LwL-eaIntereSt UebL, iS t,ne Onl,y rliLu elemrient in the iloW of servlce

payrments. Equally rigid, from the viewpoint of the balance of payments,is the service on loan capital borroweu by private parties in the debtorcountry. On the other hand, it has been a fairly widely accepted assumptionthat returns on equity capital fluctuate wihn export earnings.

66. If foreign capital is invested in export industries, one would expectthat profits and dividend remittances would fluctuate pari passu with, and inthe same direction as, the coumtry's export earnings. As a matter of fact,these fluctuations should be even more intense, since profits generally showwider amplitude of movement than gross sales. This hypothesis was tested on asamfple of developing countries. They indi-cate that in the majority of countries in the sample there was no such automa-tic tendency for profits and dividends to fluctuate with fluctuations of exportearnings. This is an unexpected and yet logical result. A partial explanationseems to be a change in the pattern of foreign investment. The major concen-tration of foreign capital in the earlier periods of economic history wasin production for expor-ts (so--called enclave investments). Consequently,profits moved parallel with ex:ort earnings. Today,foreign direct investment

- 25 -

in less developed countries flows into two distinct directions. First,there are still countries where foreign private capital is invested inextractive industries,e.g., petroleum, aluminum, other minerals. Thisflow continues to account for a major part of private Hirect investmentin the less developed countries. In these cases, profits fluctuate asexports f'luctuate. There is, however, a second set oi countries which areestablishing industries producing import substitutes or completely newgoods that are sold on the domestic market. Foreign private investmenthas been playing a considerable role in this development, not only withresnect to consumers goods, but also in the fields of capital goods andbasic chemicals. Domestic demand for these products is increasing rapidlyand without much fluctuation.

67. The implication of this latter development is that a change in theeconomic structure, which will have f'avorable long-term effects, has beenaccompanied by an increase in the short run rigidities in the balance ofpayments of these countries. Their exports still consist of prirmaryproducts which continue to fluctuate, while profits of foreign-owned com-panies, some of' which are liable to be transferred to the parent organi-zations, originate in a rising and barely fluctuating market.

68¾. In Chapter V it will be shown that the oroportion of interest anddividend payments to export earnings will increase during the initialstages of economic development of' many countries. The net effect of thiswould be increased significance of a relatively rigid factor in the balanceof payments of developing countries. But at the same time, a structuralchange in their economies is taking pl ace,- nnd increased rigridivt in thebalances of payments, which is temporary, is a reflection of the structuralchange.

(c) Debt service - amortization

69. Thiere has been considerable dispute as to whether the amortizat;ionelement, in debt service should be counted as part of the re3pht service"burden" of a developing country. On tlhe one hand, it is the exceptionrather than the rule that the less developed count-ries a re, eyx~nt.pec toreduce the absolute level of their debt in the near future, which wouldhappen in the case of net repayment. The industrialised cnuntries havieshown a continuing interest in economic development of the less developedcountries. Furthermore, as grorw-th accelerates, the profit rate in thedeveloping economies should surpass that in the countries that are

Dled>inutilie,a orarztin --nbeet inr-rtr-cture

facilities and skills improve. This upward shift in the marginal effi-cincy Of capital in the developing countries will inevitably lead toan expansion of private caoital inflow into these countries. On the,.+ hhr,, 1 w.A In ,-.; +I contr - ,s n nA Ant+ +_+-i- adi n ALi U&1I 4. I aL IL l,1 ,,i,A VCt I. VC Li V .LLv .1V

5LuSE LIL W i.; VJ..L, VLLIL |L* .SU.LiV l LV A L V V V t1 Lv iASlAv a

obligation to extend new loans offsetting or more than offsettingpayments Uue on tUllie 'loaris of the pastVU. 5im-lMarlI y, pvate ceL4 4, flowsare liable to fluctuate. Thus, a less developed country may from time to

- 26 -

time n 4itse'lf ,1,akin4 n repaymenJ It of external clebt, even 4hou.h1 -.4general t;endency is for the debt to rise.

70. For purposes of assessment of balance of paymnents vulnerabilityto short-run cIi se, Ulie 4qbUeLI Uof [1JC ex.ltig UdtUU wiLL or wilJ.l

not be rolled over at all times should be considered as part of the generalproblemt of predicting foreign capital in-LL.ow. The contractual obllgationto pay arnortization exists irrespective of what happens 'o other items inthe balance of payments. Inihile, in general, new carital iniows inay tendto outwe-igh amortization liabilities, the irony of the situation is thatprecisely when a country is facing liquidity diificuities, creditors,faced by unpaid or delayed bills, may be comnpelled to refrain from rollingover old debtes and extending new credits.

71. The llost severe liquidity crises are caused oy 1he concent.ratiorn ofmaturities in a short neriod. Ii the debtor country has to repay a largopronortion of its debt within a few years; if no fcreign exchangereserves have been accumulated to erable the retirement of the debt; andif the creditors are not willing to undertaKe the refinancing of thedebt - liquidity difficulties will be acute. A vicious circle of a sortexists. Creditors may be reluctant to reschedcule the debt over a longerneriod because of their past experience: rescheduling if ould not helpmuch if the debtor were to pile up new short term debts as soon as theexisting ones have been funded. On the other hand, the debtor country,if it is unable to space over time the maturities, is almost compelled toresort to more short-term borrowing, frequently at prohibitive interestrates. Its debt structure worsens further, Breakdown is avoided ifthe debtor country drastically curtails its imports and thus releasesresource:; for the liquidation of short-terml debts; this helps restore itscredit abroad, althoughn in the meantime the -;rocess of econonmic growthis arrested. Jilternatively, creditors may agree to postpone collections,and this provides a breathing snell. But if the postponement is onlyfor a few years, a new liquidity crisis occurs in short order. Thissuccession of crises inevit;ably affects the flow of lona-tern capitalthat is needed for development. And it may happen that developmentalreturns to new investment are high. but these iimvestment opportunitiescannot he exploited because the debt serviciing problem at Dresent isacute. The debtor countrv may be an excellent credit risl- over thre longterm, and at the same time an extremely poor risk today.

72. The number of countries where unfavorable debt structure is thenain rea.-on for hebt servicing difficulties Is limited, half a dnozen orso. On the other hand, this group includes several very important inter-nationa' debtorsq so-me of which; judging by their nosttar record of'economic growth and structural change, may be in the forefront of develop-ment, to.rmc.rrmT. Th esno:iution of their "cash=sueeze problem would -

remove a major obstacle which stands i.n the way of a possible rap-d accumu-lation of cnital in these coun+ries as- ed b- -new c^pital in4-flow.But the solution is unlikely to prove lasting unless

- 27 -

an advance is made in controlling the factors responsible for thefi;nnci,-l crises tha+ h-v been. experienced.

73. Th causes ofl u-"avorab'le d'ebt- st-ruc-ares arc comp-lex and inter-I J* . lZ kaL O I) U.L±a ) KL u ISV )u .saU a . ,SI

1CJ Lh4 tC.

related. Four of them can easily be singled out:

(a) In cases where export declines occurred, the affected countriesusually resorted to borrowiing abroad, mostly on short-term, to compenisatefor the fall in exchange receiptsc If a quick recovery of exports follow-ed, these short-term loans could be repaid on time. But when the exportdecline wvas more persistent (e.g. in the case of coffee producing counm-tries - see para. 37), quick liquidation was much more difficult.Creditors usually agreed to extend the repayment terms, but only for afew years. Consequently, a heavy overhang of such "compensatory1? indebt-edness has remained in several cases.

(b) Paradoxically, an overhang of short-term debt was incurred] insome case in the periods of export booms. Too optimistic expectationsregarding the duration of high prices, coupled with imperfections of themonetary mechanism and of monetary policies, have occasionally led toexcessive spending and thus to excessive imports.

(c) liuch of postwar financing of purchases of capital equipnernt,particularly industrial machinery, was, and still is, conltracted atmediurm term. These medium-term credits have been extended generouslyby the industrialized countries, concerned wviith the promotion of theirexport trade in competition with each other. Since the capital-importingcountries were unable to finance the purchases of equipmen-t out of long-term money borrowed in the world capital markets, they resorted tocontracting medium-term credits as an inferior but easily availablealternat;ive. These medium-term credits account for a large part ofinternational indebtedness today, and they weigh particularly heavilyin the dHeht. structure of those developing countries which have uncdergfonea structural change since the war by expanding substantially their stockof fixel capital in the industrial sector.

(X) IA number of developing countries have at nnp time or anotherexperienced inflation-induced increases in imports (see paras. 49 and 50),and some of them are stilL in the midst of most serious in-flationariyf.pressures. Unless these pressures are accompanied either by ruthless*mrt+ cntrolsn or by¾ flPibl-e exchange rate practices, exce- demand

inevitably spills over into extra imports. If sufficient foreign exchangereserves are not available, imports are bought on credit, short-andmediurm-term. Furthermore, if monetary expansion has been accompanied byacceleration of investment - quitc frequent phenomenon in th.e early

- 28 -

stages of inflation - additional imports of capital goods join the streamof addi.tional imports of consumer goods and raw materials. After theinflationary spurt is over, the country finds itself saddled with mtchshnrt_-rand mredium-term debt. And, of cnursp all the fonr causes tendto reinforce each other in certain periods. But whatever the precisecauiven+.J- li.nVs -nFl ind +.lnteractionns the problem orf rnfAirnrabhI debth

structure is there ..ith its ccns cjuent inp.zt cn . ccuntr'r crcdit-

71. +T+-n,A tota to this ch-apter, shows for a ew f- t- cmnl t ,q, - -i- V P -: IJ -- ^b1U W1L - WLC, b S.VV -7 nJV , ' - 7_ II

of countries, the proportion of public and publicly-guaranteed debtl-repay--,,bl ove-r next- fiv years. Also shown are the pror+iono

external ee/rnings absorbed by debt service (amortization as we'l asinterest)2'in a r t------ year, the ratio of foreign exchange r toimports in a recent year and the recent rate of export growth. ThereasoninUI underlyig U>e utae is as follo-ws. hle iigIer tIe proport onof debt, repayable over the neyt five years (Column 1) and the higher thecabsorp'iof of c-=-eni exchange earnings by deuubt evice (C1WTII 2)J Uhe

more difficult is the liquidity problem. But if the exchange reserveratio i.s high (Column 3), so-rre cashn Io}' meeting the maturlities is availabue;and if exports grow rapidly (Column 4), there is some elbow-room forhandling the liquidity problem and also, the creditors may be more readyto roll-over the maturities when they know that the flow of foreignexchang;e is increasing rapidly Altnougn the tabie may heip identify themos-t obvious "cash-squeeze" countries, no definitive conclusions wit;:arespec-t to individual countries' liquidity position should be drawn fromthe table. Not only are the statistics too rough and incomplete, buteven the methodological framework for analysis of individual country casesought to be different. An estimate of all prospective debt serviceliabilities for the next few years should be worked out, to include, inaddition to public debt service, comnlmercial arrears as well as otherprivate obligations for which public authorities have approved a transferguarantee . Against this, all prospective cash availabilities in foreignexchange should be estimated. Only such a comparison would indicate theseverity of the "cash squeeze", since only then would it be possible toanalyse what level of imports the country could finance after it has metits debt service. 1Tould such imports be above or below the "minimumtolerable level"? The next step in the analysis could consist of estima-ting what additional imports would be required if the process of capital

1/ Original maturity of one year and over.2/ On public and publicly-guaranteed debt with original maturity of one

year and over.

- 29 -

formtion were to be res-unled in accordance i;th +he coutry' capc ltyto carry out good investment projects. At this point the liquidityandJ t-he 6 aIntlvse .wouald MCI.ere intf o one whLlole. This two=te

analysis is not illogical in view of the fact that we are dealing witha deveLojp±ing UdebUUor Uc.tUr1U±y.

5. Inter-relatio Lships aulor,g the llquidity valrables

75. The preceding review snows tae complexity of tne liquidity prouwm.The number of variables is large and our knowledge of their likely be-havior is still inadequate. No single variable by itself is sufficientto permit a complete analysis. Conceptually, it is possible to combinerelevan-t variables into a meaningful framework. A simple framework forhandlinlg the "cash-squeeze" cases is given in the preceding paragraph 74.The present state of knowledge does not permit satisfactor-r handlingof all variables, particularly of the ccmpressible part of imports, andtheir obverse, the minimum tolerable level of imports. The final choiceof a country facing liquidity difficulties is between the minimumtolerable level of imports and debt servicing. In this, as in manyother respects, there is an analogy between an individual and a country.For the individual also, when his income falls, the choice is betweenpaying his debts and meeting minimum subsistence expenses. The questionfor him, as for a country, is how far the belt can be tightened.

Table 6,

Debt Structure, Fublic Debt S2rvice Ratios, Exchan-e Reserve Ratios Eind Export Growth Rates

01) (2) (3) (4)Country Scheduled amortization Public debt Service Foreign Exchange Reserves Anniual Rate of growth

over the next fivie years as percentage of as percentage of' imports, in export vrolume,as percentaage of out- exports of goods and 1962 recent years orstanding debt as of services, Unconditional Conditional 1950 Is

Country - 1962 1462 Liquidity Liquieity

Brazil n..a.(extremely high) 20 11 17Argentina n.a.(very high) 22 12 14 3,.9Philippines 158 3 13 11 3,.1Israel 51 29 86 5 19.0Spairn 50 2 66, 12 9.1Mexico 149 16 39 20 3,,Turkey 48 17 30 12 1.6.aiwan L47 5 61 n.a. 10.6El Salvador 145 3 38 11 9.9Chile 44 25 15' 10 4.1N4icaragua 44 5 37 12 1,5Ethiopia 42 4 72 18 2.6Costa Rica 141 9 17 12 7.9Burma 140 n.a. 77 17 0.4Colombia 140 11 20 8 3.1P'eru 140 7 21 8 6.8Iran 38 9 36 13 n.a,I'hailand 36 3 loci 10 6.4Ecuador 35 8 34 12 6.1Korea :33 n.a. 27 n.a. n.a.Sudari 33 9 64 7 5.2Nigeria 30 2 60 11 4.3Bolivia :25 n.a. 8 27 n.;a.]ndia 25 9 26 24 1.4Pakistan :23 7 445 25 0.4Ceylon 22 1 259 13 1.5

'17 - 3.0*'''s -*sL~ t 4 .f ) ,Uialaya 16 1 94 5 5.0

(See notes on next page)

Notes to Table 6: Countries are ranked according to how unfavorable their debt structure is (Column 1). This i;

not necessarily a rank:ing which indicates the gravity of the liquidity problem.

Sources: Co:lumn 1: IBRD, Economic Staff Statistics DivisionCo:lumn 2: Table 7, Chapter IV of this studyCo:lumn 3: Table 4, Chapter III of this studyColumn 4: Table 9, Chapter V of this study

4

- 32 -

CHAPTEIR IV. DEBT SFR-VTCi R-TIO

1. Ratiorale

76. The preceding chapter has already made use of the debt serviceratio (para. 74 and Table 6), this familiar ard r.ost frequently usecdrule of thumb in appraising creditworthiness of borrowing courtries.The ratio signifies the proportion of foreign exchange earrings oncurrent; account (i.e., exports o^ goods and services) absorbed bypublic debt service (i.e., both interest and amortization). The useof this concept has been criticised, even ty those wrho have been usingit, as an inadequate measure of debt servicing burden. And yet, t1leratio has shoirm strange powiTers of survival. The reasons are many, butthlree stand out. First, it is a seemingl simple and easily under-standable relation - debt service against exports. Saeondly, it canbe ccmAputed on a firm statistical basis - it does not require the u.eof national accounts with all the guesses incorporated in thcir cor.pila-tion. Thirdlv, economic analysts -who have been aware of the imperfec-tions of thie ratio have failed to suggest an alternative. Tn the absenceof a comprehensive indicator of debt servicing cauacitv. whether fromthe short or long-run vieApoirnt, lending institutions have had to resortto the use of nartial indicators.

77. This chapter di scusses some of the features of the debt serviceratio-, but the final judgment reIarding its validity asac rm-easlre ofdebt servicing burclen has to be postponed until- the very end of thisr+-'Axr ,rnl-r 4'+y +1,4n o1 U _ + c-vP A-+ n_-; .c. ' r c r nr., fir

V~~~~~UV,,. Vf' 4iQA . x U\. 2DDL.tfl U. 11C % U V L V U S Q1 v L' w_±X5 waya.~. l J

has been explored in Cllapter V, will it be possible to come fully togrip7s -With 4his eluiv -o.e^t A t- - -- Z-atisti ca.' mat;eria' -I wiG recesr.~~~~ ~~~~~~~ ~~~~~~~Is. S~~~~~~~~~~~~~~i ui . L ~_LtA ~ vL V0UJ U )u~ UJLJu U_U~ - IIr Ui _L L- Io_1U LII I A UI

debt service ratios calculated according to various definitions of debtser-vice are p-esnte i, Table 7 wWf-LCU is at'uadned Lo Utis I(;apter, .4fairly representative gl'oup of countries is included.

78. The m.erits of the ratio as an indicator of short-rmn rigidityare stantial. An oalrli study red In prepae BD'au 'u-nk explains tuhsaspect of the ratio as follows:

The magnitude of the ratio of debt service to foreign exchangeeaVn-rngs is ,.. relevant to appraising the burden of debt obliga-tions in the contex-t of cyclical or other short-term declines inexternal receipt5 ... A Phigner ratio of f.ixed service commitmentsto external earnings implies a considerable short-run rigidity inthe debtor country;s balance of payments .. . the ratioindicates the pressure to which debtor countries may be exposed inperiods of dovnward movements of their foreign exchange earnings."_/

1/ Dragoslav Avramovic, op. cit., pp. 101-103.

- 33 -

79. These pressures may be extremely strong. During tne GreatDepression of the 1930's, the ratios of public debt service to exportsreached extremely high levels: wnile export values collapsed, the fixed-term burden remained unchanged. In Chile, debt service obligations atthe depth of the Depression were higher, in absolute tenTis, than thetotal value of exports (see Table 8 attached to this chapter). Liquiditydifficulties proved insurmountable and several countries defaulted.

2t Limitations

80. There is no doubt that debt service pressures exist also today,and they may well be exemplified by the size of the ratio. Only recently,the finance minister of a debtor country was quoted as saying that nextyear there was a serious debt servicing problem since debt service fallingdue arnounted to 43% of expected export earnings. It is not difficult tospot liquidity problems, actual or potential, once such numbers arereached. But from both the analytical and the operational points of view,more interesting is the auestion whether a debt service ratio which issubstantially lower than the one quoted above, may in some way point tDthe emergenne of debt servicing difficulties at some future date; and ifsuch "critical" level of the ratio exists, what is it?

81. It is only natural to attempt to identify this critical level byreferring to the past experience= But. how relevant is past experience?As mentioned in Chapter III, fluctuations in receipts, either on currentor on capital accounit are much Iess now than they used to be. whilerigidities on the import side have increased. The net effect of thesechanges irll vary g're-t.ly from countrv to country. Further; one Tray arguethat the "opportunity cost" of default is greater now than in the earliernperiods of financial hiist.oiry, qsince capit.a1 flnows are now 7hoth largerand more stable, so that the "typical" debtor would think twice before hewent into default. But here again, some countries get more foreignloans and some less, and therefore the "opportunity cost" will vary.Perhaps mrt. imortant,policyir rspnsesn to balanre of pynn ts pressurPes'

inevitably differ from one period to another and from country to country.For these re-a-son-s, if for no other, ats to idenify the rlialevel of the ratio, at which breakdown of the balance of payments is

likey t ocur, avebee lar,el *vnsucessul.A recent e~ssay on thecapacity to service debtlJ concludes that:

" History provides little guide for determining the rmaximum /debtser,--!cf

7 rat4o which4 C antries oudithcut rdeffanult oTW_ -V I U .X D wll | 11 ULI 1 - JC- V

without interference with the transfer of earnings. ArgentinamaintUained investumient s0eIrv l ce: ln the.-L lat 180' _L+ an invesLme

payment-current receipts ratio of over 4o per cent; but the countrydefa-uted on public debt obligations in 1933 with a ratlo of 36 percent,* and restricted transfers after 1947 with a ratio of only 10 per

1/ Raymond F. Hikesell, "The Capacity to Service Foreign _nvestment", in:U.S. Private and Government Investment Abroad, University of Oregon,1962, pp. 382-3.

* Defauits wiere confined to obligations of provincial and municipalgovernmnents; the Argentine government did not default on itsobligations. (Ed. note).

- 34 -

cent (in 1945). In 1889, Argentina!s ratio rose to 66 per cent,highest ratio in recorcled history, but she was forced to renego-tiate her debts in 1891. Australia managed to avoid defaultsduring the 19301 s with an investment service-exchange income ratioranging from 35 to 44 per cent during the 1930-1934 period; andCanadal s ratio reached 37 per cent in 1932 without defaults ongoverrnment obligations or the introduction of exchange controls oncurrent transactions. ... Thle degree of tolerance varies considerablyfrom country to country with the breaking point in most countriesduring the 1930ts at 2'7 to 30 per cent. On the other hand, it wasa sharp rise in the ratio resulting from the precipitous fall inexport earnings that brough-t about the defaults."i/

8o2 The . i c reason f'cl- fai1uhre to i dnntifV the c.ritical level ofthe ratio is the fact that the debt service ratio combines only twova,irinhl rt ou f nine H scisse in ('Ch-apnt.Pr TTT TIt. isq trive that thevariables that are related in the debt service ratio are crucial - debtse-,-rvice nQ n nli asa n,e z t tea ,onr flow of rny'-ferablp resources.;Nevertheless, the remaining seven variables are disregarded, and soMeof them may on particular occasions be of decisive sigificance. Inother words, even if the amalysis is restricted only to the liquidityas'ps+ ct,- o I debt seviing± capac t,hat Js the- UXl.- end of oeamorgeneral problem, the debt service ratio is an incomplete measure of'>Ih UUd eb It± VicingIt UUrdUenI, IIUVJeVecrl m,± LL .L ay be U th va.iable. L-IJo lVl--l

are inco)rporated in it.

83. In some cases, the application of the ratio as an indicator ofrigidit-y mraly be lnappropriate for special reasons, ri_d othler partialindicators may be more re:Levant. Tile two types of cases where thisholds are listed below.

84h Tl-iere are countries in wfhich the relationship of public debt ser-vice to public revenue portrays more accurately the liquidity problem.The extreme case is countries ijhich do not have control ov..r their ownmoney suLpply - for example, countries covered by the Last AfricanCurrency Board. It is characteristic of such cases, roughly speaking,that monetary arrangements ensure that balance of payments problems clonot arise: the public authorities cannot print money or borrow from acentral bank in order to cover deficits, and therefore cannot spend riorethan they receive from revenues and frorm genuine borrowing, internal orexternal. In such cases, the burden of servicing debt is in tcrms ofcurtailment of public expenditures, and only via that, of curtailment; ofimports.

85. In other countries wihere trade is large in relation to total econ-omic activity, and particularly in countries which are also poor andsmall, .institutional freecdom to create money often does not give nichCL

1 Sources quoted are: David Finch, "Investment Service of UnderdevelopedCountrie s", Staff Papers, International i'ionetary Fund, Oeptember 1951;and Drag-oslav Avr&movic, op. cit.

additional flexibility, since such inflationary financing is likelyto have immediate repercussions on the balance of payments. In suchcountries, present debt service liabilities and the prospective increaseof service liabilities may not appear large in relation to their externalearnings. But they may be large in relation to, e.g., the publicrevenues, and strains on the fiscal system may have immediate adverserepercussions on the balance of payments. In these countries, then,although debt servicing difficulties are in fact operative at the levelof the balance of payments, nevertheless more sensitive indicators ofimpending- difficulties may appear at the level of the public financesor of the internal savings-investmnent balance. Consequently, the analysisof the liouiditv nrobhem in suc,h cnses has to incellude hoth she nressureon the fiscal system and on the balance of payments.

3. Long-run Relevance

86. The debt service ratio is a versatile instrument. It is an in-complete and imperfect indicator of short-run rigidity; but as though tooffset these handicaps, it has certain relevance for the "psychological"aspect of creditworthiness. Foreign exchange is one of the scarcest,if not the most scarce, inputs for the developing debtor countries bothover the short-run and over a longer period. The debt service is acontinuing charge against this scarce resource. It is an indicator, ifagain an incomolete one, of the strength of the temptation to default.As an indicator of temntation, the debt service ratio does not explicitlytake intco account the dlisadvantages of default in terms of reduction ofborrowing facilities or deterioration of the terms on which it would bepossible for the country to borrow after default. Implicitly, however,both the borrowers and the lenders presumably terd to compare the sizeof debt service liabilities with that of the likely capital inflow. Inthis sense the debt service ratio is a convenient yardstick of the"sacrifice" or "benefit foregone" of maintaining service. As long asdebt service is low, it clearly does not "pay" to default; if it becomesvery high, then it is natural to compare the gain from default withprospective capital inflow. But the question again arises: what is"low" and what is "high"'? And whatever "low" and "high" may be, are theythe same for everybody and under all circumstanceso

87. The significance of the debt service ratio for long-run analysisof debt servicing capacity is virtually nil. It has already been shown,in Chapter III, that the size of the debt service, and thus of the debtservice ratio, is heavily influenced by maturities. VJhere the debtservice ratio is undulv high owing to hurched mediium-term maturities.it does not indicate the extent of the charge on the balance of paymentsin the long run.

QQA h udna ifclv oe epr -edb e=Ac rt.nio

is a cash flow concept rather than a profitability or productivity concept.Because it is a cash Ud flow conceptU, itU includess amortvization. as- a charge.

But debt, whether of a corporation or of a country, is normallyr,lled over; ard whenevFr it is repald, it cannot be expectedthat a very large part of the total debt be repaid out

of a year's income. The same cash flow element is anparent in thechoice oi the other variable in the debt service ratio - exports.Exports are gross sales abroad; but they are orly one segment of totalsales of the country; and certainly they are not the economy's profits.The concept which charges amortization against yearly gross sales mayor may not be a good indicator of the potential cash squeeze to whichthe econorimy may suddenly be exposed. But it is certainly not anindicator of the ability of the economy to sustain over the long runthe debt servicing burden, which is inte;:est.LJ For such an indicator,or a combination of indiciators, we have to lnk Plsewh2re. IWJhn in-vestors lend long-term money to a corporation, they lcok at the funda-mental factors bearina ng on it +.f ure profitability: its potential rateof growth, its net earnings and their behavior over time, its abilityto appl inn--+- - -onA to-,A+- a to technolog n1 ,n e rA4 h ro "vQr-

fied its output is or may become. To be sure, the investors also lookalu 'LI Ue.i± curr t pUci p osiWI1U _-4-y __-4-4-- _--±- Ud--dIJJ y 4 bs

corporation currently has troubles with its short-term debts. But oncethese troubles have been seqTtled, one way or another, the investors arenot much concerned with cash flows at some future date, and they do notcompare amortization due in, say, ten years, with gross sales eithernow or then. What the long-term lerders are concerned with are thefundamental factors which make for success or failure. Similarly, in1the case of a developing country, the decisive factors are whether debthas been incurred for productive purposes and whether both the loanmoney and the country's own resources have been invested in a way whichmaximizes total output and savings and which makes the economy moredynamic and resilient. The behavior of the ratio of amortization andinterest to exports has very little relevance, if any. In fact, the nextchapter shows that the ratio will very likely increase for some time inthe process of growth and that, from the long-run viewpoint, there isnothing necessarily alarming about it.

2 The debt service ratio sounds as though it has some resemblance tothe rules of thumb used in corporate finance when appraising credit-worthiness of business firms. The similarity is superficial, Thenearest concept in corporate finance we could find is the ratioI:Times Interest Earned". This concept signifies the relationshipbetween net earmings of a company (before interest) and interest onits long-term debt. This is a nerfectly logical concept; a chargeon profits is related to aggregate profits. (It is interesting tonote that different values of "Times Interest Earned" aDpear to beconsidered acceptable or "normal" for firms in different sectors ofthe economy: much less stringent seems to be the normal value for apublic utility wdhich has stable income, while a much higher ratio isrenuired in a volatile induistrv like electronics or steel.) Theproper application of the same concept for a national economy wouldhe the rhl ati onshn between its net sv-in,s (before ebht seroice) and

interest on external debt.

- 38 -

Table 8: Ratios of Public Debt Service to Exports in 8 Latin AmericanCountries in the 1920's, 1930's and 1950's

(in percentages)

A. Prewar

Argen- Colom-Year tina a/ Bolivia Brazil Chile a/ bia a/ Peru Uruguav

1=926 L.o0 7 3 13 2 5 5 2-7 2 6 7-61927 7.9 6.1 14.4 8.7 4.4 3.2 9.21 92R 8.9 8.=5 11-.6 9.5 8.1 6=o 8.51929 10.b 7.8 16.5 9.2 11.9 7.4 965

1930 18.2 13.5 23.5 18 .0c/ 14.0 9.5c/ 9.71931b/ 22.5 24l .5 28.L 32.9 15,I 1 IA 3 )1932b/ 27.6 50.0 41.0 102.6 21.8 21.4 36.31I 3-/ 30,2 3B. I 5 ' .A 21. 7 3I1.

B. Postwar

1953 1.3 12.7 4.8 7.0 4.7 4a3 3.11L95I 2.1 19.7 8.4 7.7 4,3 3.8 4.1L955 2.r 5.3 20.8 8.7 7.4 6.5 6.4

1956 1.9 4.1 12.2 10.3 6.o 9.4 5.

1957 7.L 1 2.2 16.4 11.7 i2.1 LI4 86.L958 12.', 12.4 20.2 12.2 2L.1 9.4 8.4

1959 16.C) 7.1 17.9 12.1 25.1 8.8 11.7L96o 23.5 11.2 21.8 15.0 17.0 ll,L1 8.0

1961 26.1 24.7 17.6 28.5 16.0 7.6 6.11962 22.8 7.1 24.2 27.6 13. 7.8 6b.8

a/ In the 1920's aid 1930's, debt service of national mortgage banks is in-cluded.

b/ Scheduleci public debt service as a proportion of exports. Bolivia, Peru,Chile, Brazil and Uruguay defaulted dulring 1931; Colombia during 1932;iArgenti-na and Cuba partially in 1933.

c/ Probably underestinated.

Sources: Debt service in the 1920's and 1930's from Peterheinz IIerhahn,Kapitalexport und Schuldentransfer im Konjunkturverlauf, Jena 1937.SubseqLent debt service from International Bank for Reconstructionand Development, Economic Staflf, Statistics Division. Export clatain the 1920ts and 1930's from League of Nations, B.eview of forldTrade. Subsequent export data from International i4onetary Fund,Irnternational Financial Statistics, various issues.

L-C)

93'9�� 7 '-: fl9'1-9<-t a --"ro,-'t - � o6 I:, 77IV�¼' <7Vi�P �''t ii�9 9-991- - �'.99 �", .� � 9� UI9 1� 99999 999919 9j39.� 99'19 196- 9

� 91 919 19 9�9j -'9919 9 �9- H HID 9' "6 9 9 99' 9 9 9 9 H- 991 9 9" 9 9 9

9 9

9' 9a 93:49194 9 99 99919 I19 '991 p,: N

H 9 9.Vt - �-'��I-1

9'439 99

'-99 DJj 99 9 4 it- -'34:9 49: p 99 9 � , 351-"-"H 1-9.9.31.91-4 NA.¾4P'9- '999996911 919104< 9293901-NJ <C F-

919 <399 34 99 9'99- 999 OH

Hi 9 � � 993.9 0672 9 - '� <�- �t4 ��9:l9 4CtMZ �3�69 49 972,499 9 99� 90 9<3+9 '31'-'9 991-' 9 '-1199 99 91 9999 99 I- 9 '.4 9 -. 91-P9- 4--: 9 9 9

9.9

�.9 4!

� �-<6 9.9. 9�, 499.�39 439:999 i�$ 09.1-9.9. Jo 9

-'H,-'- .99917 7.9 1�1-7 .99 -, I t � 9-Vt .9 909- 9-09.91- 9ffj'gj%' V-z>71'6t

9419 I -. 1� 79 V'I L6DH� . 9.91-1-9,- %�999 g9H9'� **(4991:3 H*� 9 I'"9:3 9 9 "Fd9V'-� 9� 9 9:99911 � 99H'9:909' -'99 33� 'D9H9 99. 999. 999 9 H- 9 97241-1 9i'-�o 9 £ �' 3- I -9' -c 99' .9 99 99. l49�. 9- 9.

9 99:- 9'99.9 H 9999 9'9 4 9 99999 99999 39999p399 .919 � 99999 �999'� I"--' 9�4

19-9'',9 '-19009309. 9949-1-99' 419''l* 9.0 9. 93999391 9099 .9H19 99.94" J9�z9�'991 -� �-2 91,419

11-99 if 9-9 9.,- �:99 91 9 g9

:9 �39 9 9 9

'-'4 9'399 9 Dl'9.9 999 9994 *3�999 99,499 999999941- 9" "9999 99999 991499 99999 99999 � '9 1-tV-' '9'-

�9 9049)

999 41 99999 '9.79 nIl -.909- 3)01-4.909.3-72(399 9..949 *-�'+ "720.I-9. 9. ".9-,-I

V � 9�' �k' - 99999 99.99 997:99 3999 99'93- '� 99 9729 9.9.99- 9999.9 1.-1' � 9'9'-� 99-9- 9. 9 39999 .3D3 9 972999- � '9 ii:72 '3

99 9: 9 4999 3. 9�09 � 91 99

999 39.9�9 V9 9999 99999 9999 99099 0994 PD'-' 9999 99999 99999 99 HI-' HD-'9. 9334 (46199 99�72 -9 * 9.911-" 91934939. 9.9993< 9. 3-9"

'99 .99' 9-9 H 9)99 9: -"99 9,99[3 919."'91" 9-�41 p�.g'�v� � r1- .7 -�> V '--'.11: ��ifr�' 9Z� � ,99999 9-999,4 99-749-72 9.13 .3't-'u'p. �9 991994.9 99 9 -- 9 99 .4 � 34 �1D 191-72 :4:1 3-' 9-01-99:49 9 6 9 9-9 9.99 949 9 9" -"

9. 9 9 91 9.9 1<9 9

93 99199 99 1-- 1-99 994: 1- I'

99 1.199- � 99999 99999 999934 99:999 93499

41::9:99 99999 99999 99999 9999 HHH -'949.9.9.I-I -9:993909 '9�t-C993

CHAPTER V. THE LONG-TERM ASPECT OF DEBT SERVICIING CAPACITY

l_ Torvel of Annlircia

89 The long=+e. aspect of debt f.erriiing ty aciti1 su fn-iicon the benefit and cost of foreign capital to a country in thegro,N'th process. Conceptually, +he cost=b'e.nefl a y c be interms of specific projects financed by foreign capital or in terms

Vl' macro-econ1UILL Jlidgi± -lUUCdes OkUA1 dC? 0O CdV 11, l1VUO VAGLI U, 4JLAr4s

exports, and imports.

90. Ideally, benefits of foreign-financed projects should takeaccount of direct and indirect effects, external and internaleconomies as well as the proportion of the income stream generatedby the initial investment which is saved and reinvested. Tihe calcu-lation should be in terms of equilibrium prices which reflect thescarcity of various factors of production. Ivierely to define thenature of the calculation is to suggest that probably it is non-operational at the present time. The Bank's experiences in this fieldindicate the difficulties of dealing with indirect effects and ex--ternal economies, not to speak of variables such as the extent ofincome plough-back. In any case, equilibrium factor prices (shadowprices) cannot be determined at the project level; they are a func-tion of developments in the over-all economy. In addition to thesediificulties of measuring benefits at the micro-economic level, thereis the problem of how to interpret the cost of foreign capital. Fora particular enterprise, as a rule the cash cost is reasured by theamount and time sequence of debt service payments, i0e. interest aswell as scheduled amortization in the case of foreign loans. However,f'rom the standpoint of the whole economy, the net charge of foreigncapital depends on the behaviour of future gross capital inflow.If maturing loans for particular projects are rolled over to financeother projects, amortization payments are not an immediate cost tothe economy,

2. 11acro-Economic Benefits

91. For these as wel:L as other reasons, it is convenient to ana:Lyselong-term debt servicing capacity in terms of the behaviour of macro-economic magnitudes. 'In this context, the role of foreign capita'L isto supnlement national resources in raising the rate of capital forma-tion and/or certain kinds of expenditure (e.g. education) akin to in-vest,mennt Griven the level of per capita income and the nressure of

population growth, there is a considerable gap between national sav-ings and a desirable rate of investment in many deveopTing conntri-es.In some cases, the gap is widened by the phenomena of capital outflowfrom these countries. Not all national savings are available to frin-ance domestic investmeent.

- 40 -

92. Ry making possible a higher rate of investment than wouldotherwise be feasible, foreign capital raises the rate of incomegr ti1, hothe- tl-.e acce:Leration of' rn-oe gro.sth is proportionar1-e

to the increase in the ra-te of investment depends on the behaviourof the margi nal cIpitaoutput rt Prir. there i litl-

reason to assume that the marginal ratio is eqaal to, higher or lowerthan the average ratio.27 experience suggests almost corplete agnos-cism on this score. The magnitude of the marginal ratio is a functionof natural resource endowment, efficiency in resource use, randomrchanges in capacity utilization, durabil-ty of assets created by irvest-ment and technological change.

)3. The savings-investment mechanism is at the center of the growth]process and foreign capital can play a crucial role in this process,under certain conditions. Benefits of foreign capital depend on thequality of the recipient country's resource use and resource mobiliza-tion. Conceptually, the effectiveness of resource mobi-lization policiescan be judged by studying the biehaviour of the marginal savings rate,i.e. the proportion of the increment in income which is ploughed backc as

savingrs. The higher the marginal rate of savings, the greater the LLkel.i-hood that the borrower can service foreign capital and sim.ultaneouslyr re-

duce the savings-investment gap. Surely, the absolute value of the gap isnot likely to decrease and even a relative reduction (foreign-financedinvestmient as a per cent of total investment) may not materialize inanediate-ly. But if the growth process is successful, then there should be arelative narrowing of the gap within the lifetime of a generation.

Qbl The effectiveness of resource-use policies cannot be judged by anysingle measure. The capi-tal-output ratio is not an unambiguous indicatorof efficiency (see para. 92 above)" The appraisal of resource-usepolicies must rely on answTers to a series of questions. Are the greatmajoritv of nublic expenditure decisions based on systematic evaluatiLon ofcosts and benefits? How much waste is involved in the form of "prestigeprojects'1 ? To wT1ihat extent is tariff and nrice pooicv the result ofpressure exerted by sectional lobbies? Does the institutional struc-turein agi culture thwart the incentive to experiment with new crops and newproduction techniques? To what extent is policy regarding industrialHza-tion- and import substitut:ion infruenced bv non-eeonomic ccnsiderations?

Is the government administration capable of taking speedy decisions or isthe preparation and implementation of projects uninstifiably delayed'?Qualitative assessments of this kind must be supplemented by statisticalindicators such as growt-h in total output and measurement of structu^'a lchange.

1/ harginal capital-output ratio is defined as the ratio of investmentto increase in output. It indicates the yield of investment interms of addition to real income.

2/ Average capital-output ratio is the ratio of total output to existingcapital stock.

- 41 -

3. A Digre.ssion: The Adjustment Problem

95. The savings-investment gap is equal to the foreign exchangegap, by definition. However, this is no more than an ex-postaccounting equality. Ilore interesting is the mechanism by whichthis equality is brought about. The capacity to transfer savingsabroad may be underminecd by a deterioration in terms of trade.The foreign exchange gap, allowiing for the movement of export andiamport prices may be much larger than the savings-investment gap atconstnmt prices. W hat analytical significance should be attachedto this divorce of savirng and transfer aspects of debt servicingcapacity depends on the period under consideration. In the short-tern or cyclical context, such an adverse movement in world demandor supply conditions may underlie the liquidity crisis discussedin Chapter III above. However, the deterioration in terms oftrade may have a more permanent quality, if it is the result ofstructural or policy changes in the pattern of world consumptionor production, For example, the major export. commodity of aborrmoier mav be the victim of Engl Is Law; the demand for it maybe declining, relatively or even absolutely, as income of consumer'sincreases, A primary commodity may be disp1Lced by technologicallysuperior or cheaper synthetic substitutes. New and more efficient,su ppliers of the snam rL..-r or com.todi. mtarn Pr.ter the world marketand displace existing exporting countries,

96 Countries affectedl by such development in the world economyought to be able to ccnx-nsat.e for them in the long rlun Variousavenues of compensation are possible. The threat of competitionfro- s-ythetics may +t some extent be met by p'oductivi ty -hangesin primary production, The case of natural rubber, where it maybe possible to secure puLbstat 4a-' cost reducti>cns I-y -replrArtia

with improved materials, is an example, Factors of productioncan be shifted, at least at t,he marg'in P fo 4traditi+'onal + eFort

activities to new primary exports.

.97^ However, it is highly *unlikely that the developing countriesas a group can solve their long-run transfer problem. only byr cost

reduction of existing primary exports or by developing new ones,,In terriLational uIe&aemenud for m,any pr-iryary products imLreases at aslower rate than imports of materials and equipment required tosusta.in a satisfactoury growth ur iincomie. Consequently , importsubstitution, chiefly i4 the industrial field, is the typicalpattern of adjustment.

5-, The problems of adjusting to structural changes in the worldUeconomy are not confined to less developed countries. The Britisheconomy is still in the process of responding to netq textileproducers. The United States is at present adjusting to theregained competitive strength of Europe, The countries of theCommon Market are beginning to feel the impact on the internationalmarket of the recent growth of Japan. The difference between the

dilenmma of primary producers and that of industrialized countriesis in respect of the required period of adjustment. Factors aremuch more mobile, institutions are much more adaptable and skillsare much more widespread in advanced, diversified and industrializedcountries than they are in the under-developed world. Indeed,

- 42 -

one can say that the relative absence of resilience and dynamism is one ofthe important characteristics of primary producing countries.

99. Import substitution in the industrial field, however successful,is likely to be a time-consuming process. Industries have to be esta-blished and they have to go t;hrough their infancy, When they finallyemerge on the world market iri competition against existing producers,one may say that they have matured0 And only then will the developingcountries have fully solved their transfer-cum-growth problem.

100. Developments in income, structural change and trade policies ofindustrialized countries exercise a pervasive influence on the ease ordifficult;y with which the long-run problem of the borrowing countriescan be resolved. The more rapid is the total growth of the world economyand the more liberal are the t;rade policies of creditor countries, theeasier it1 will be for borrowers to grow and to service foreign capital.

4. Macro-Economic Costs and Their Time-Sequence

101. To recapitulate. benefits of foreign capital depend on: (a) theefficiency with which resources, including foreign capital, are trans-lated into income, (b) the extent to which the additional income streamis saved and used to finance domestic investment and/or public develop-ment expenditure, and (c) the raniditv with which internal structuraladjustments are made and then reflected in the composition of importsand e-nnrt.s

I )2o These hpnpfits irl hphoulb crmpared with the cost of foreign capitalThis cos-t, in macro-economic terms, is determined by the conditions(inLterest rate, grace period, period of repayment) on which externalcapital is made available and the ragnitude of gross capital inflow inthe future.

103. TheJ+,,y,c -v of 4 c al inflo vre i erent stages

.-- J* -- _ ~i ~J - d.u JAiJ. £L'W V ~± ~ i Uj~.I.L_t51.tZ;IU ov rK,

of wihat may be called the debt cycle; and this cycle, in turn, is closelyliree with .,+ h e couse of econor,,i develpmen.

the following highly simplified reasoning. In the first stage of thedevelopment puroes it is normal for a country to borrow enough externallyto finance not only the gap between investment and savings, and not onlyto meet amortization charges but also to pay interest on external debt. U/

I/ Trhs is one way of expressing the relationship between domesticaliygenerated savings, current foreign capital inflow and debt serviceon inilow that had occurred in the past. Another way of expressingthe sate relationship would be to say that capital inflow continuesto finance a part of domestic investment while a part of domesticsavings is used to service foreign capital.

- 43 -

In this way it obtains a net addition to its domestically generated re-sources available for investment. During this stage the burden of servicingforeign capital to the national economy is zero, or, more precisely, theburden is continuously nostponed But the consecuence is that externalindebtedness increases rapidly; since interest on debt incurred previouslyis nni d nut. of npw hnrrownig whc rh als o arrie sc i nterest, thp familiar lawof compound interest operates in all its force. A.nd the lonuer the firststage lasts, the stronger are the effects of the law of compoud interest

105. The second stage of developmen+ begins w7hen the vol--e of grossdomestic savings equals the volume of gross domestic investment. Thecountry no lon--er re'ies on external caplt4-a' for finncn 4 4etmn

but it is s-till borrowing abroad to make service payments on debt accuiau-lated An the fir stage i. The_ cU..4y beins t4o- sevice fe capita4

by paying interest; and as the second stage proceeds, an increasirg partof tite interest costu is paid out of domestic savings. No net t

talces place yet; but as borrowing at interest to pay interest beccmessmaller and smaller, external inUdebtednress rises at a pace -which iscontinuously diminishing, And at the very end of the second stage, ex-ternal debt reaches the reak and ceases to grow; the apogee of tlhe curveof the debt cycle has been attained.

106. As the second stage ends, the third stage begins. Domestic savirngsare sufficient to finance all domestic investment, and in addition theyare enough to pay for the entire interest cost of accumulated debt.During this sbage, the country begins to generate a surplus of savingsabove domestic investment and interest payments abroad. The countrycan start amortizing its debt, while maintaining a satisfactory momentuimof economic development. The law of compound interest now works inreverse and outstanding external debt diminishes rapidly. The countrynow pays back all the cost that it has pos-tponed in earlier periods.The debt cycle has been completed; fore-ign capital has helped thecountry to enter the continuously rising upward curve of economic growth;and foreign capital has been repaid after earning interest throughoutthe period of its employment in the borrcwing country.

5. The Extremes and The T"Typical" Case

107. Thexe is nothing inevitable or automatic about this progressionof debt from the first to the third stage, because there is nothingautomatic about the process cf economic growth. Many things can gowrong, and t;he country may never leave the first stage, i.e., the stagein which its debt continuously tends to increase. ,here poverty or acontinuing deterioration in the terms of trade make it difficult toachieve high marginal savings rate; or where capital-output ratiobecomes prohibitively high because the efficiency in resource use ishandicapped by the scarcity of skills and paucity of natural resources,there the growth-cum-debt sequence will not work, because there is nogrowth. If' the social rate of return on investment is lower thanthe rate of interest on borrowed capital, and if the marginal savingsrate is low, the borrower will exmer½nce viciously rising indebtednessand, by definition, an urmanageable debt burden.

c8, Are there countries in which the rate of return is lowyer thanthe interna-tional conventiona:l rate of interest, of, say, 6 per cent?We do not know. However, the possibility cannot be excluded thatsuch cases exist, Among countries which are today engaged in attemptsto raise the standard of living of their peoples - and the number ofcountries is around one hundred - there are bound to be some wherenatural obstacles are so severe that the returns on capital are very lowqIf international transfer of resources is considered necessary in suchcases, such flows must not be provided at conventional terms if virtuall;ycertain debt failures are to be avoided.

10., At the opposite end are countries where conditions are extremelyfavorable: output grows fast, the plough_back is large and increasing.,the rate of return on investment is high, the composition of outputresponds quickly to external demancd conditions and to the country'sgrowth requirements. In such a lucky country, the stage sequence ofthe debt cycle may not take place because the borrowêr is toosuccessful. Foreigyn in-vestors are eager to employ their funds in thiscountry, wthether the country wants it or not, heeause returns are largeand secure. A country which has fully succeeded in the growth processmay not reduce its indebtedness at all, i.e.2 it may never enter thethird stage. Its situation is analOgoUs to that of a successfulcorporation wihose d.ebt grows with its min grawth. This is a well knownand perfectly logical case of "Unto everyone that hath shall ob g-ven".

110 Instead of reducing debt, such a country starts exporbing capital,while aqt the sam.e tilme continuing 1;o, b-orrow abroad. Llconomnic hisstO-,yhas a number of such examples, The most recent experience is that ofJapan and Italy. Fifteen years ago, economic forecasts for thesecountries were not too exuberant, in view of the structural problemswhose solution seem,1ed to require a very long tire, The forecasterscertainly did not envisage the impressive record of growth andstructural change which 1has been attained in less thanl one-hal- of thelifetiire of a single generatlon. The marginal savings rate must havegone up rmore, an>d the capital-output rat-io must have been less than wehad anticipated; and those countries' breakthrough in the world marketwi+th an ever increasing variety of products, competitvi-vely producedand sold, has surpassed all expectations. These countries have becomlean increasingly a-tractive field for, foreign investment. There areperhaps today several developing cotntries rrhose position is notdissimilar to that of Japan and Italy at the beginning of the 1950Os.

Ill.. If such a phenomenon like a "itypical"i developing country existedat all, it would probably stand somewhere in between the two extremesoutlined in paragraphs lO-llO. Fhe difficulty is that "1somewhere"still encompasses an uncomfortably wide span. Given our present stateof knowledge, our insecurity preverts us from dividing the

t t'somTewherell into mnore precisely defined subgroups. To do this, w-'ewould have to identify the specific countri-es which wculd fit a shorteror a longer time ndth of the growrth-cum-debt sequence. AJnd wqhile wehave some saspicions that division may nave in fact already occurredwithin the developing world we wiolLd still prefer to dodge thisissue JIn the present stuly.

112. Consequent-iy, the expcsition which fcllo;Ts is a -reat sinupli-lication of reality. ITe have constructed a mathematical -,ocelto portray the possible behavior of tl.e 'key variables relevant forlong-r-on iroirth, partly financed by fc,reign carital. Differentvariants of this mo6el c-an be constructed at .will to fit variouissituations by using different values f'or particular vcriables. Sincewe are manioulating oiily one vcLriant, tne choice of valuls is nec, ssari-ly highly arbitrary anc' tl-eref'ore the findings arD subject to severeliiaitations. Nevertheless, we hav.- f(ult that even a very s3iirlcnumnerical illustration of the -ro-th-cui-debt sequence iwiy th2owlight on some of the critical problems facing the borrowers and thelenders at the present junctilre of economic history.

113. The purpose of thiis piece of algebra is to slhowJ what conditionsmust be met f'or a develonins country to be able to leave behincl theperiod of growing debt in the not too distant future. The benchmarkof a quarter of a century has been caoseen on the aEsurption that thedevelo,ping, andci the developed countries. in iriakin-! their x_recentdecisions to borrow and lend, respectively, want to have sorte i.dea,however hazy, of whether the- can see the lignt at the end of thetunnel within the lifetime o-f a gener-ttion. T'ne other Pournose of themodel i.s to shouTJ what hanoens to the relationshins of the variablesin the process of' ecofnomic grorth. In i-narticular, attention isfocussod on the relationsnip between ne.t and ,ross ca-ital inf£1wjon the ratios of debt service to total output and to oomestic savings,and above all, it is focussed on that king-pin of the conventionalanalysis of creditworthiness, the debt service ratio.

- I~ -4°

6. The iodel and its Assuiptions

L . The hypothetical country, -,nich we want to analyze, has thesechara+trirt c+.; o

(a) Income Grow1th Target. The desire` rate of iincrease ngross domiestic product (GDP) is five per cent per annumcompoundhJ and ±r emainsot. v ir This is fairly

representative of =rowrth targets of the developingcountries. ".-so, the Xlliance for -roTress has fixed atarget of 2'- per cent annual increase in per capita income,

.k 4 I;_ 1 4 4A - Ak _F -1 _ - - - - - - - -P -_ I - 4 4 7A4 ;VJ[Ii 1-11 dM UJ._e OU l,L 11OU i1 CI U 1 UDk1 W> UL CU _ UDU aXVU,

per cent p.a. This is also the goal of the U.N. Develop-menlt Decade, recomraen.led by the Gen-eral c isser_Ibly. Asample of 33 countries shows that l1 of them actuallyattairled a grocwth rate of , per cent or higher during th-Lelatter 1950' , Ano-ther f6 countries experienced ratesor growtih between 2 per cent and 5 per cent p.a. Onlythree economies failed to realize even a 2 per cent p.a.

increment. (See Table 9, attached to this chapter)

(b) Savings Rates. lnitial gross domestic savings rate isassumed at 1() per cent of GDP. This assumption compares'ith tlke finding that 2) countries in the sample apparent-

ly have savings rates above 10 per cent, other 9 countriesbelowi 10 per cent. The counrtries excluded from the sample be-cause f inadequate statistics, most likely have grosssavings rates under 10 per cent,

harginal savings rate is assumed at 20 per cent and re-mains constant. This target is below whcat many nationa:!programs postulate but is probably higlher than manycountries heve actually achieved. It is not entirelyimplausible, given national determination. In a recentstudy, irrof. Rosenstein-Rodan has suggested that develop-ing countries should be able to generate marginal savingsrates double the average. The irmiplication is that if westart frorn an initial savings rate of 10% and if themarginal savings rate is 20k,, it will take about 15 yearsto achieve an average savings rate of 15%e.

(c) Capital-Outpuit Ratio. The ratio of 3 : 1 is assumred, a.ndit remains constant. This implies that a unit of grosscapital inpu-t yields to the national economy 33 per centin terms of gross value added (wages, profits and de-preciation). Ailthough considerable analytical work hascentered around this concep)t, statistical studies havenot yet been aole to determine its rorecise behavior incdifferent countries and at different stages of growth.

- 47 -

Since the assumed target income gro-wth rate is 5,% p.a. (see aabove) ancd caDLtal-o-atpLT ratio 3 1, the required invest;nent ra1teis I5',) of GDP. Since the initial savin-s rate is 10%, the gapto be financed by foreign capital inflow amounts to one-third oftotal investment. ilany developing countries nave investment ratescentered around 157.

(d) ExDort Coefficient. -[nitial proportion of exnport earniLngs tototal inccrme is 10 per cent. The sise of the export sectorvauries greatly among developing countiries. In many cases exportsare 29 - 305 of GDPi-. `Joe have deliberate' y chosen to illustratethe case of a more closed eccnomy. The n;ost oopoubous amongtht developing countr-ies have an export coefficienit below 10N. Exam-ples are India, Pakisastam Brazil (see Table lOa po. 62a).

(e) Export growth rate. hxnorts are assurred to grow at )% n*.a. Thisis an extrapolation into the future of the grouth trend ex7eriencedby the less developeJ countries as a group in the last decadeor so. Between 19<0 and 1962, the volume of totalexports from the developing countries, including the petroleum-based econom-les, increased at an ann-cal rate of 3.9',, while theaggregate exuort value rose at 1.; p.a. There imay be significantco-untry deviations aro anc this average.

The choice of the exoort gro¶ith- rate of L, does allow for thepos-ibility that counltries like Brazil, ilexico, Colombia, India,Fakistan, the PhilipuL:nes, ,oderately sacceed in the near futurein e xpnr' in- their e-xJorts of mranufactured goods, on the basisof structural cehanpes w1hich have already tak-en nlace or arecurrently under waZ7

The model docs not apply to countries based on exnorts of primarynro(hiuct.- fo-r wThic_h Tm-orld r4P-rinrl rises verv r e petril Piirn.

or aluminun. iLor does it amply to a group of developing countries- ITrqel, Vi.cc ola-ia, Tai ,an = ,,hirh havc recen+l r atanedsubmtantial grow-tn in total exports based, on exports of manu-faic-tu res (over-all exrPort gro w4th rate m ore teanl p.a.).

(f)0_ C Forei 4- t al 1 nta des.t s sue to be zero).This is not a representation of reality. It is anandaLyical device wvhich facilitates the presentation,

at the expense of oainting the ,Acture nicer than it is.Further assumption is that gross borrowing takes placewithout interrunttin in amounts required to bridge thesavings-investrnent gao and to cover debt service payments.

(g) Debt Service. Foreign cniital is borrowed at an averageinterest rate of 6 per cent ner annum and average maturityof IC, ±xr-r terms fair]y rpresent.ative nf conventionallending.

7. Fi ndi nscc

I15 I ½ these stylized assumptions, the debt cyrcle spans 36 years.The phese in wihich indebtedness rises lasts about 25 years. This isfollowec by a decline over ten years. Debt retrns to zero i n t'he36th year (Chart T).l/

116. The 25-years period of r±sing indebtecness has two stages.(Chart II) Dring the first 15 y c Ia inflw QsIIplerrentsdomestic savings to finance part of domestic investment and at the

Debt installments, as they fall due, are paid out of new debts that-are contract-ed. But ;9is UY y r s , ZUC Is t1hi s done, 4h country

obtains a net addition to resources, on top of repaynent and on topUl ±1.U liLlv U, I L1. I1l U xJA Lk LI LU' JIi Ut JjIsj _'dU Vt U'JI U i . UI U 1l U i U Q1 U t3.1 I

capital to investment.

117. The second stage of rising indebtedness covers the rest ofthe 25 year eriod (see para. 1i6). Domestic savings, under theimpact of high plough-backs out of rising output equal, and thenovertake, doomestic investment requirements. The cradually growingsurplus is used to cover part of the debt service, and the balanceis met out of new borrowings. This leads to further increases inindebtedness, although at a decelerating -pace, until the debt ce2sesto grow in the 25th year.

118. In the third stage, growing dmnestic savings are sufficientto finance domestic investment, to pay interest on debt outstandingand to enable net retirement of debt. The 36 -year cycle is abridge between poverty andc self-sustained growth.

1/ The underlying computations are in the files of the Bank's FconomicStaff.

INVESTMENT ISAVINGS AND CAPITAL INFLOW IN THEEPR'OC'.ES"S OF ECONOMIIC DEVELOPMENT

F-IRST !STAGE SECOND sTrAGE - _ THIRD STAGE-_________

RATIO OF GRtOSS CAPIT'AL INFLOWTO GROSS DOMESTIC INIVESTMENT

40%/ _

I ~~~~~~~~~~~RATIO OF GROSS DOMESTIC SAVINGSTO GROSS DOMESTIC PRODUCT

2 0 %/

0 I 2 3 4 56 789101 1012 1314 15 16 17 IS 19 2021 22 23 2425 2627 28 2)3031 3233:34 3536 3738 39 40

YE ARS

IBRD - Economic Staff --42253 t

TtiE DEBTr CYCLIE (6%io P'ER ANNlUM REPAYABLE IN i5 YEARS)3, C) 0 0 1 1 FFFJIFI T

LOGARITHMIIC SCALE

2,000O - - _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

FIRST STAGE- F->-C-SECOND STAGE 7 -HIRD STAGE

I.C)00 - = I 4 = *

8300 de_ - - - _ q -

SOO- =~~~~- I L- - _ _ _ _ _ - - _ _ _ _ _ _ _ -

I_t____I_I_II_i_I_I_ I -II 1 -a-111!I 1!!|!! f

-- ar~~~~~~~~~~~~1400 #I-

(0 I 2 .5 4 5 Ei 7 8 9 10 11 12' 13 14 15 16 17 18 19 '2O 21 22 ;23 24 25 2'6 27 28 229 30 31 'i2 33 34 35 36 37 38 39 40

YEARS

,BRD- Econoi-nic Stcjff D

226,2 -_ _ _ _ _ _ _f

REQUIRED ILEVEL OF CAPITAL. INFLOW IN RELATIONTO DOMESTIC SAVINGS; AND INVESTIMEVNr

--cC- - - - -FIRST STAGE SECOND STAGE _' THIRD STAGE:

1, 20C _-

GROSS DOMESTIC SAVINGS S-(INITIAL AVERAGE RATE, 10% OF GDP, MARGINAL 20%) o /

_ OOC) -- 7 f

80C ) - - _ _ __ _

600t -_. -

o * GROSS DOMESTIC INVESTMENT|. - 000 (I15% OF GDP)

40C) ___ -______

;S-~~~~~~-

20C)-___-_ _

- ,,_- - -NET CAPIT-AL INFLOW _GROSS CAPITAL INFLOW

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 113 19 20 21 22 23 24t 25 26 271 28 29 30 31 32 33 34 ;35 36 37 _38 39 40

YE ARS

NOTE ALL DATA ARE ANNUAL I

IBRD - EconDmic Staff

2252 -.

Q ualifications

119. The quick retirement of debt shown on the charts, is just onereilection of the rigidity of mathematical models. OJlly i.ndlvidUalsand corporations afraid of the future retire their debts; no countryliquidates its liabiiities completely. Secondly, only a very few coim-tries today start from zero debt; most of them are already in debt, mndits size varies greatly f-rom country to country. Tirdly, our statiSticsmay be good enough to indicate ahether the plough-back out of income gener-ated by new investment is high or low, but they are still inadequate toenable us to specify values for this variable in different countries,FourttLly, we do not know enough about the developmental returns of capital,and therefore we are uncertain about what values to choose for the capital-output; ratio. Fifthly, the relationships in the model imply a very slowgrowth of imports. There have been cases in economic history where ifastgrowtl-i in output has not been associated with rapid import increases. bultthese cases have been rare. Difficulties in containing the derand forimports would imply either a longer period of borrowing or more borrowing,or moSt likely, both. Finally, the assumption that the values of thevariables remain constant throughout the 36 -year per-od is artificial.If the country decides to raise its income growth target above 5;io p.c.,the resource gap iTll widen and the amoint of needed borrowing will in-crease. The opposite would happen if the income plough-back rate (mar-ginal savings rate) is raised above 2Cfo . Perhlaps most important, whenthe growth process is truly successful, the rate of return on capitalshifts upwards (the capital-output ratio falls'. Once the increasingreturns start to come in, all be-Ls are off: the postwar exuerience ofJapan and I-taly is repeated (see para. 110). Foreigners will want toinvest in the debtor countrvy the' return on foreign canital. instead ofbeing taken out of the country, will be reinvested in productive assetsand will nontrihntp. to further incrpases in domrstAn. income The lnva ofcompound interest, instead of strangling the debtor, now works in hisfavor in the form of the laTwr of growth of nroductivity. The debt cycledoes not run full course because the country has become an attractivefild foCr lnvestmen+.

120) Th)e rang Lo *f variqtinns ii -nf;ini+.p Anrd H.. iznr'it.o nl thipimperfections and uncertainties of predicting the future, the approachmbodied in the growth model may be perhaps better than alternativeapproaches to the analysis of long-term debt servicing capacity. Partial

tndicator, such asshotw ;.Tables 9 and 10 (atace to hi chptr)give us a picture which is necessarily incomplete. Only by relating the

relevant variablesUUA~ inI.ome fictional pttern, 11 -D ossible_ to deuce-U,

however roughly, the shape of things to come. We cannot determine thepreci;se time -eriods ofP 4the debt4 cyc-le but-4 wecn--.a,i,prsinO~~ ~ .LAJ~Q ~J± ULIZ LLt~UU ULLk' LV~~ Ud.II ±0±111 dIi .LZIJIjj -- io.LU11 WI._

the direction in which a ciountry can be expected to move. And by varyingthI value of uhie critical variables we, carn form1 an npressiun of aiter-native developments which are possible.

121. Furthermore, there are certain general conclusions to be derivedfrom the preceding analysis, which may be ap,licable to a 11typicalldeveloping country. The nature of the debt cycle and its relationship

to economic growth would be as depicted in the model, unless return oninvestment is below the cost of borrowing or domestic savings neverexceed domestic investment.

9. Gross vs. Net Borrowing

122. One significant aspect of the growth-cum-debt sequence is therelationship between gross and net capital inflow. While capital in-flow is a net addition to domestic resources for the first 15 years,borrowing continues and debt increases for another 10, because domesticsavings are still insufficient to pay both for the domestic investmentrequirements and for debt service abroad. Alternatively, one may saythat borrowing continues simply to meet service payments on previouslyincurred debt. And this is largely the result of the caDitalization ofinterest during the period when the borrower is unable to pay interestcharges from its own resources. Had the canital been more nroductive.had the economy generated a higher rate of savings, and had the rate ofinterest been lnwer, this extra npriord of borrowing couild be shortened.And conversely, a less productive capital, a lower rate of savings, ora hi gher rate of interest, would tignifican.tly extend the period nverwhich debt continues to increase simply to enable payment of interest.Stated slightly differently, the length of the period of gross borrow-ing, the size of the gross capital inflow that would be needed to yieldany gi-ven net1 if"'Lo.w ofL resoar ces, and the lev. L V.L ofLL UtsLding iL Vdet^d

ness that would result, would all be very much in excess of the magni-Ludes so-wr, in dIthe chIICu- ts ,W.I I I l pet toL I those L.IL.L Lotri whIJII InIee

net additions to their domestic resources for a considerably longerperiod than L years. The potentilal gravity of the indebtedness problemin such "long-haul" cases is exemplified by the mathematical certainty

'li.at UebUtl incurred atl' 6%t p.a. do-ubles every twel-ve years if. interest icapitalized and no retirement takes place. It is not difficult to compute4, -_ ," L -.__ _ULl1 ;s-ze ul indueuubeuness anu u± debu service nur to iMagile 1te asdsi-ciated problems of liquidity, if net addition to resources were needed for 30or 70 years, m5stead of ior 15 years as assumed in our model and if loanswere to be contracted at 6% p.a. interest.

123. The "long-haul" countries can prima facie be identified as thoseL | _ _ q . . . > . . . s s~I . I - _

with very low per capita income, large population and relatively poornatural resources. They are likely to be dependent on foreign funds forquite some time to come. Such cases exist.

124. Tne reality does, however, provide some redeeming features. NotaLl foreign capital consists of hard loans. Part of the flow of resourcesis in the form of grants or loans repayable in local currency. Even loansrepayable in foreign exchange do not in all cases bear conventional terms.A part of resource flow consists of equity foreign investment and part ofits earnings is reinvested in the country in productive assets. The long-haul cases are no doubt there, and they are very important. But perhapsthey are few.

10. Debt Service Ratio Revisited

125. Now the spotlight can be turned on the debt service ratio (Chart IV).On the assumptions of the model, the debt service ratio, starting from zero,attains a peak value of more than 501% in the middle years of the debt cycle,

IRATIOS OIF IDEBT' SERIVICE PAYIMENTS TO GROSS DOMEsTrICPRODUCT SAVINGS ANqD EXPORTS..)

-F'IRST STAGE -b --- SECOND STAGE -THIRD STAGE-_______

-RATIO OF TO)TAL DEBT SERVICE...... ~PAYMENTS TO EXPORTS

400/%_

RATIO OF TOTAL DEBT SERVICE ISEVC PAMNSTSVNGPAYMENTS TO GROSS DOMESTIC IPRO[DUCT

1 '3, 4 5 e 7 I0 II IL I.J2 ' -4 IJ 06 I7 10 i9 2 2i 22 23 24 25 26 27 20 29 3U3 3 3 34 3:5 300 37 318 39 40

C-)XYEANRS

BRD - Economyic Staoff -H225G6

and declines thereafter.lj W4hatever the rate of growth of exports, the ratioof debt service to exports would be always higher than the ratio of debtservice to total product, since exports are only a fraction of domestic product.What particular peak the debt service ratio attains depends on the initialratio of exports to product and the rate of growth of exports.

126. So far as the initial ratio is concerned, the model assumes a relativelyclosed economy; ratio of exports to income at the beginning of the debt cycleis taken to be l10. If the assumption had been, for example, 20% (see againdata in Table lOa), the height of the top line in Chart IV (ratio of debtservice payments to exports) would be reduced by half. However, it may sohappen that in particular periods the most difficult long-run problems ofinternational financing are encountered in relatively closed economies. Iftheir popu:Lation is large and :income fairly low, the need for external capital-will be very large. If this need is financed predominantly on hard terms andif exports do not grow rapidly, the rising debt se.-vice may cause a threa-' toliquidity which idll be critical, and the debt service ratio may be even muchhigher than 50%. Furthermore, if savings grow only sluggishly, so thatindebtedness continues to grow., we would be facing a situatiorn in which anextremely tenluous financial position would last decades. This would be thesituation in 'loniz-haul" countries. whether closed economies or not. unlessthe average rate of interest on total capital inflow is reduced substantiallybelow 6&. or interest is not charged at all f'or several decades, or, at thelimit, financing takes place in the form of' grants.

127. The mocdel depicts an economy where relative emphasis is on import substi-tution; r.theLr t.han on ranid Py n.ni on of exports. This isareasonableapproximatiorn of reali-ty. Hapid expansion of exports can be based on increas-

.ing exorts cf primary products or of manunfactu.red goods. The growth of wnorldd(emand for primary products is only moderate. The range of manufactured goodswhilch the rre sde c t ca devA q and prdc el

for exports is limited. They consist mostly of products of the light industriesin ti at -st somle of' the 1 da countri _ -- es lave a nal atural coparativ

advantage. Apart from other problems the newly emerging manufactures have hadto resolve, they have also faced the trade o-stac1es -n the indu-+Jalzedcountries, some quite severe,2/ Problems of adjustment in the latter have thusfclar prevented ---- massive ----- ircras ---- eA t of' "ih mr,-afac'ures fro., the

less developed areas.

1/ Such a pattern is not without historical precedent. Canada had a peaklinVest,ent1 :ierviCe ratlo Uo ))5 in 'yuL and Australia s ratio at tne neigrht uthe boom of the 1920's was 24%. These ratios exclude amortization, becausedata are not avaiiaole. Tney would be consideraoly higher, if amortizationcould be included. Both these countries successfully effected the transi-tion to low debt service ratios as the economy grew and the production baseexpanded. :[n 1961/62, Canada's investment service ratio was only 9A andAustralia's llo. Sources: D, iFinch, op.cit. pp. 77-79 and I.Ivi.F. Balanceof Payments Yearbook, 1962.2/ For the range of products to whichl import restrictions (quotas and tarZffs)apply, see United Nations, lorld Economic Survey 1962, Part I ppc 66-70.

128. Many developing countries find the most promising prospect of expansionin the field of import substitution. It is not mere accident that thesectoral distribution of foreign loans to finance industrial production in thedeveloping countries is overwhelmingly weighted in favor of production for thedomestic market. It is somewhat ironical that at the project appraisal levelthe emphasis is on import savings, while in the aggregative analysis of debtservicing capacity, the emphasis shifts to exports. In countries where bestprojects are found in sectors that will predominantly produce for the homemarket, exports are bound to develop slowly; and if foreign capital ha,helped with finance the debt service will rise in relation to exports. Itis a mathematical certainty, that the debt service ratio will increase and,other things being equal, the rate of increase and the ultimate level willbe determined by the size of the capital inflow.

129. Sooner or later, however, the change in the economic structurewill have its effect on the composition and growth of exports. Tnereare already several postwar cases where domestic industrial expansion hasbeen followed, after a rela-tively short time, by an equally rapid expan-sion of industrial exports. In other cases, the lag may be longer, andin some it may be quite long. But as the domestic industrial expansionproceeds and production becomes more competitive and distribution systemsmore smooth, manufactured exports will also increase. As they expand andas the relative role of foreign capital in the domestic economy diminishesunder the impact of the rise of domestic savings, the debt service ratiowill assume a declining trend. This is also bound to happen if thegrowth process succeeds.

130. The debt service ratio lacks any theory that would support it asa meaningful indicator of the lorg-run aspect of debt servicing capacity.The only important factor from the long-run point of view, is the rateof growth of production (Chart V). In the process of maximizing benefitsand minimizing costs, individual sectors may go forward or lag behind.Exports are one of the many sectors of the economy. And while over thelong run they have to expand if the economy is to grow, there will beperiods in which the law of comparative advantage dictates otherwise.It is only in the interest of the borrowers as well as of the lendersthat output and savinps be maximized, since they are the only real sourcefrom which debt service is paid. Additional foreign exchange earningsor foreign exchanen savlngs are only an outwarri expression of the deeperprocess of growth and of capital accumulation which inderlies growth.If the rn te of return on capitalI domestm i and foreign, is hi h! if theflow of good investment projects is large and increasing; if the ploughi-hnbk of rrofit.sq is subantial; nri if theo nprrouiot.ir)n st+.riuctu.ire ardant.squickly to the reqluirements of growth, the long-run debt servicingcapacity, should increase . The rise and fall of the debt service ratioare peripheral phenomena to the process of growth and capital accumu-lation

1 11 flees1nn-h +.hi mnonn +hn+. +hc rvA+.i ; i n iolsa1 o rrnron+. iinro-r -1 1

circumstances? If this were so, it would not have survived this long.Desspite all its ime.erfcctions, it does serve as a convenient yardst ckfor passing short-term creditworthiness judgments, that is to say,Judgments ofL thLe r4sk- that deful ra be prvoe by4 liuiit criesJ I1.iA J UI ± M LAId 1 Ue.Ldau.Lu mayd~ 'Ue proUvolKe. 'U)1 li..Luiulu. C.T ISE;d

While the debt service ratio is an incomplete and imperfect indicator04'~~~~~. Lrsn orpoenil qu1UldDy problems andu should never bue used

in isolation of all other variables relevant to the appraisal of theseprobUlems, it dUoes 'draw attention tLi o the cashii fLo-w squeeze towhich an economy in the process of growth may be exposed.

IMOVEME N'T OF OUTSTANDING DEBT IN RELAT'IONTO GROSS) DOMESTIC PIRODUCT _

7 , 0 0 0 I i I I i i I i -i I i I I i I i i i

i ~~~~~/1

6,000._ _ ___ 7/FIRST STAGE SECOND STAGE - -THIRD STAGE-/

5,000 _ - -7_ _

| ~~~~~~o//

4,000 _ -7_ __l < i~~~~~~~~~~~~~~~00

.00, 4 GROSS DOMESTIC PRODUCT000 (GROWTH IRATE 5% PEfR ANNUIM COMPOUND)

3,000_

2,000

1,000 -_ -,[ ,,_ __- - b ~OUTSTANDING DEBT

-.F -, - .! -, ! - L

Cl 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

YEARS

IBRD - Economnic Stciff -t2254X

132. It has been stated several times in this study that vrowth largelybased on lmrport' sal Vin gds rat:nedr than on ex7Aor'U ex GX -J 'd 1-IU -4or 4 -Ul y

in the balance of payments over the medium term. The compo-ilion ofiriports steadily shilfts in the dlrection of inflexblbe iripui . aspurchases of raw materials, fuels and in some cases, even essentialfoodst-uffs increase. Exchange reserves are kept low because domesticopportunities fur fixed investment outlays expand, and also) ire.c,ontlyuecause of poll 2y errors. On top oI these infie i b±;L-Ties coeses t.ede'-" service whiich, at the peak of the debt cy- e in our mordl: ruu uptco as much as 5U0% of export earnings. Sven if import subs-itutioii Processis perfectly suoccessful in curtailing, relativc.Ly, the demc:;d for foreignexchange; and even if the flow of export earnings remaining availacleafter debt service is sufficient to meet the most essential importsneeded for economic growth, the vulnerability of the balance of paymentsto disturbances remains form-idable. The debt service ratio may not bean enri-ei.y satisfactor:y measure of vulna--:Ability; but the problem isno less formidable for being imperfectly measured.

13'3. By now our analysis has run the full circle. We have startedwi.th the examination of the short-run aspect of debt servicing capacity,and then moved on to a review of factors deter:aining the lcng-run growthaspect. The reverse side of the latter; however, is increasedvulnerability to liquidity difficulties, at least for some time, whichbrings Us back to the analysis of short-run factors.

l134 If economic growth of the developing countries is to be fi4cancedpredominarlvy en conventional terms, the creditors will have to adjust tohigh (and in some cases very- high) debt service ratios, i.e. to considerablesuscentibilitv of the balance of pavments of their debtors to liquiditydifficulties. An alternative, which is already being resort-ed to on a largescale, is to provide sizable and steadily increasing assistance on "soft"terms. Another alternative is to put ceilings on the assistance that ismade avail labIl to develcping enucLmries, be it on "hard" or on "soft" terms,irrespective of whether the prcjec-ts submitted for financing by the countryconcerned are profitable. Assiming that the "hard" solution is the prevailingone and that, in consequence, creditors are asked to tolerate a very pre-carious liquiditv situation of many debtors. certain implications arise withrespect to the policies of these debtors, and also, with respect to somieother general maLters. These issues are discussed in the conclusions ofthis study.

I - - U~~~-ac---t -gr --t -

Cooctry G~~~~rowth in output Irwe ... th -rt v oeZebnto eiset tut of Socings Rate, f taxtoFortIes decent Faftoes iteoentY-gvotevt -- -~~~~~--~--' -- Imor gro-ot-h-c---F iaete Ib.- it-t

Ft Price stroctoreg~ a,gYears s-core years va-or~ ~ ~~~~~~~~~~~~~~~~~~~e., r--:.t duI;4ng recet fzfttin years

Athn 1a ne n.. na oo / .. ra .. ne'8v na .. ne 6.4 A 1Ar,e tntul . . 1.3 3.9 n..2.]? 1.018 3.11 0.22 0 u 0,/:1067 C n.5coliven. 0.? n. /1 /I p.b /h /b lb /D8 - n... n.e..B2be-il G.. .04T 172 .. 5 78 7 B n.a. 9.0/i 10.0q/a C n.a.burma 6.1/. 3.5/a 3.? 0.1 0. 78 75 75, 75 18.0)78 19.5T8 A 40

Ceylo- 3.2 3.6 1.9 1.5 2.9 0.L11 0.39 0.70 0.915; S .. 6.5 18.5 A 22Chili, 3.3 3.,. 6.9 4.1 n... /b 0.67, /b 0.56 C 0 *11.2 14.0 C 4.Chi . 7.9 7.5 9".1 10,6 7.0 .e n.e. n.un. .e,c I - 15.2 15.5 8 47Coloo,,bi. 4.6 3.9 1.4 3.1 6.3 0.51, In 1.77 A' n.e.. a 9.2 11.1 B 40Costa Rita 9.0) 3.8 3.6 7.9 9.0 0.92 3.95 0.72 7800 C - - 1.6 31.1 A 4ul

goowdor~ 9.0 4.2 8.6 6.1 3.3 /b lb lb lb B 0 0 12.9 15.? A -35E1 Salvador 9.0 3.0 n.e. 9.9 6.s 75 ,- 73 0 7883 1709 A 0 - n.0... ne A 45thtilopo n.e. 3.1 6.9 2.6 n..78 0.54 lb 1.1..a. n.e.a n. n.n.. 7.0 n... 42Ghanane. 5.0 3.2 7.6 o.a 731 0.88 78a. 0.8 A .a. ou9.9/B 9.9 B 27-moese 6.2 9.0 10.2 4.7 n.e. 1.32 0.65 1.11 0.69 C n 12.7 13.6 A n.e.

jiondaren 1~~ ~~.7 510.5 3.0 u../ /b b bC -- 7.0 8.7 B17loos 3.5 3.1 1.5/ .6 7810 nOe. 700 0 v 97.e. 6.9 9.6 B 29Iran,ne 6.0 n.. ne .2/v lb /I /b /I /I /i lb /, n.e. 6.1/d lb. 8.2/h B 38

Isruel ~~~~~10.0 9.3 16.3 19.0l 15.077 78278 78678 78.638 7831 ~ D n 21.V9787e 23 .678 h 51Ivoy Coas.t n.. 6.0o.. 09 .. nu n.e. .. n.e, A/j ly .e ne n.a. 16.173 /y A in.e.

torawa. ~~~~~n.e. 7.0 0.. 5. nD.r.. .. nu. nea .0. 0.0. 2.1 n../sKorea 1~~~ ~ ~~.1 3.6 n. n.e. n... n.e. n.a. n. - n. n.o 0 s.12.2 B 75

Malaya n5.z. 4.5 3.9 9.0 3.3 0.83 0.77 n.e. 1) 63) A n.e. 0) 13.9/d 15.1 A 16Pe-ioo 4.9 4.6 41.8 3.0 3.7 2.bO 0.67 2-L5 1.02 8 0 *.,/e 10.2/e A 49

torceco ~~~~~1.5 0.7 4.1 2.0 6.5~/n 3.38 In1.2 5 / 0) - . 11.86 A 5

Spoarague ~~~~3.6 3.9 7.1 1.95 3.5 0.79 l.J8 0.36 1988sa n.e. n.e.n.. 9.0 A 4t-tigerla 3.9 2.1 3.7 4.3 8.9 0.31 0.61- 0.33 0.0 sDuI 6.8/a 6.0 A 30a-i,,tan 1. n.e. l.a Ao 4.a4 1,b lb, b /b o .n 7.77- /s .h/e A 23

Peru 1.0-5.0 n.e. 6.7 o89 3. 5/v 78 75 T8 75 A 0 - i11.178 19.i7. B 10Philoppdne- 5.0-6.0 4.0-9.0 4.6 3.1 1.59 17.53 TM 17883 7; C 0 10.1- 10.1- A 98

deongal ~~~~~n.e. 1.0 9 9/y 10.7 ne. /b lb n.. b 0.. 0n.. 20.0/s A neSpain 4.5 /r .5; 9.1 8.0 5796 0.05 0.79 n-.,. A ne n10.3 12.8- B 50SduGa s.u. 759 1.9 5.? 1.5 0.90 0.73 n.. 0.63 C n.C. 0 n9. .5 A 33Taega,-ran.e 5.0) n.e. 0n.0. 3.5 n.0. lb /1 .e /b /1 B n.a. 0 9.8~/d 9.0 A 5...0

h-anlu 9.0 6.2 4.4e 6.1 1.4 0.9 0.9 0.I 0.9. 0 10.578 11.7 A 36

Tego .e /v /a .ia/y 12.1,/y n.e. 0.59 1.08ne. 0.0 0.. .0a. 0... l0.011 / 00

Tunisia n.e. 780~~~~~--o 4.14e 7.3- n..1.69 1.59 0.. o.65 C ne nu 10.6

1.A.6.n.. 5.0 /a 4.6 8. 5 78 n Th 78 788 B v 2 13.7 A n.eYugoslavia ~~~8.9 7.5 780 13.3 8

.~o0j 75789 1.12 7837 0.63 A ~ -0j23.3/a

SWhtsand foontcn Coflowg page.

- Of -

Notes to Table 9: Some Indicat.ors of Ecor.oic Grooth Footnotes

General: Where compound annual rates of growth inc percontafe levels haoe been. csiculated, the terminal points /a Adjusted to GOP basis.are an average of - generally - three-year periods selected to avoid undue bios. The per-od 'Fifties' generallyrefers to 1950-1960, except for some countries where data fo. 1961 and 1962 were available and for trade data /b Volume of imports not available.where the years 1948 and 1949 have in most eases beei incl,ded. The eriod 'Recent Years' is generally anaverage of the last four or five available years, nxcept for taxation estimates which refer to two or three years Sc Probably slightlv increased.only. Growth in output and rates of savings and taxation rofer to the whole economy, including estimates of thesubsistence and/or non-monetized sector. It may be argued that in some cases it would be better to exclude this Id Mid-fifties.sector.

Is Total revenues1. Growth in Output is indicated by conpound percentage annual change in Gross Domestic Product at constant

market prices. Where such data are not available, the cost appropriate alternative concept has been /g Public savings as percentage of GDP planned to crop from 3.4% in 1955-1962 to 2.0% in 1962-1968.used. Sources for data are ISRD Reports and the UN Yearbook of National Accounts Statistics. However, rev-nue excluding that of marketing boards will rise from 9.6% to 12.d% between the same

periods.2. Growth in Export Volu-ae data has been obtained fr.. the IFS and frrm data cads ovailable bV the IMF acid

which is to be published in the IFS; frem the UN Yearbook of International Trade Statistics. Projections A' Excludes oil revenue; tntal revesue including oil royalty is 15.3% of GNP at end of decade.are derived frpm IBRD reports and involve a fair amount of guesswork.

3. Export Growth Relative to Import Growth is the ratio of the rate of growth of volume of exports to the rate Si IBRD Mission expected that a lower rate of growth ould be attained.of growth of the volc-sn of imports. /j One year estimate only.

4. Output Growth Relative to Import Growth is the ratio of thb rate of growth of total outpat to the rate of /k Ratio of public savings to GNP is planned to rise frem 3.6% in 1955/56-1960/61 to 4.3% in 1962/68growth of the volume of imports.

/'I Volume of exports met available,5. Rate of Savings i.e., Gross Domestic Fixed Capital Formation and Changes in Stocks minus (or plus) the trade

and services deficit (or surplus) calculated as a percentage of Gross Domestic Product - both in current Pm Imports declined.prices. In some countries changes in stocks comprise not only normal inventory acoumulation but also in-voluntary stocks of commodities in surplus e.g. coffee stocks in Brazil. Another weakness of savings /n Imports did not increase.estimates arises from distortions caused by the existence in some cases of overvalued exchange rates ormultiple exchange rate practices. See also note to "Resource Gap" on Table 10. /o Exports declined.

Symbols: Level recent years is indicated by A, i.e., 18% or over; /p Tentative estimate.B, i.e. 15% - 18%; C, i.e. 10% - 15%; and D, i.e. below 10%.Direction of change of the savings rate is shown by es i.e., /r Virtual stagnation 1958-1960 followed by strong upswing recently.a narked increase; 0 i.e., a mild increase; e ie., no significant change;and - i.e., a decline. /s No repayments are scheduled.

Sources used are the UN Yearbook of National Accounts Statistics; IBRD Reports; and CSO publications forIndia. /t IBRD Mission sceptical about sustaining past rate.

6. Rate of Taxation is measured by the ratio of tax revenues - or, where this is not available, total revenues - /v Assumed to be equal to projected increase in value.to GDP In current prisea. Tax avernues ar-e prefered bacausa data r_adily avallble on a iomparablebasis. How-ever, exclusion of net profits of agricultural marketing boards and/or margins derived from 1w The volume of exports is expected to increase.differential exchange rates may understate the fiscal effort of some countries.Sources are the UN Yearbook of National Accounts Statistics and IBRD Reports. /x Per capita output in recent years appears to be below the prewar level.

7. Rate of Price Increase during 1958-1962 is meaeurcd by the cost of living index. Ly IBRD Report.Symbolat The average annual rate of increase in prices is indicated by:

A: up to 4% Ic tittle or no rowt.B: between 4% and 10%C: greater than 10%

The source used is the IFS and IBRD Reports.

8. Debt structure is measured by the percentage of external public debt outstanding at the latest dateavailable which is scheduled for repayment during the succeeding five years.Sources are IBRD Reports and the Statistics Division of the Economic Staff.

TA.BLE 0i, SOME DATA BEARING ON CREEITWOCRTHINSIG OVEN THE1 MEDIUM AND LONG-RUN

(I. addition to in.dicators h on T.bic 9)

C.oanry Change in terms of trade Growth in export value Groth in import vleResorc gap - Avera.ge PaPalation Ineowtmeflt i oco.ve nvesteent income_______________ ______________________________ ___________ __ _______________ ____ __________ ____________ g aa hh rate payne ts -so ofop p -y tnts am 8 oaf GG P

Fifties Recent Fifties Recent Poetd Fifties Recent Recent years maternal earningsEarly Mid Years Years years Fifties Recent Rece..t years

ye-rs

Afghanistan n.. n.a. n.a. n.n. 0.0/b 9.0 nu .... sO.n.O. 0.a..00Argentina 137 117 103 - 1.6 sc 0.0 0.6 6 1.8 1.3 6.2 0.8Bolivia 1133 119 1127, - - 0..- - 54/a 2.4. n.a. 2.4 0.4Brazil 7121 130 837 0.9 - n.m. 2.3 1.6 6- 2.4 8.4 10.2 1.5B-ra ZiGO 121 93-7 - 0.R .m 5.3 0.5 20Y/a 1.1 1.6 3.4 0.A

Cey'lon 102 JOB 96 1.7 - 0.8 3.3 3.7 16 2.8 6.5 3.6 1.5Chile 0.. .0. 0.0a. 6.6 0.3 6.8 5.6 6.4 2.5 15.64 12.2 2.5Colombia 101 131 86 2.9 - 6.7 3.0 - 2 .8 6.5 6.6 1.0Costa Rica 113 131 75 u.6 1.6 3.5 9.4 3. 22 4.3 18.2 6.2 1.0Ecuador 126 122 86 9.G 3.0 3.0 6.6 - s3.1 13.3 15.0 6.3

El Salvador n.. 123 80 6.8 - 3.3 8.9 1. a3.5 2.4 3.4 0.8Ethiopia 99 122 89 8.6 1.64 .0 9.0 7.6 a.. 15) 1.3 7.0 0.5Ohaa 36 105 57 6.2 5.9 0.0 0.9 8.9 53.0 ..a. 5.0 1.7Greece 93 92 95 7.0 1.5 n..a. 2.8 9.7 45 1.0 2.5 1.0 00H.sd-ra 107 119 88 2.3 2.7 n..5.6 2.1 10 2.6 26.5 7.6 2.0

India 116 105 11.5 0.5 0.6 3.7 2.8/h 5.0 13 2.4 3.8 5.9 0.3Iran 0.0. 00a.. 3.0 12.6 4.2 9.9- 06.2 23 2.5 63.5 67.2 11.9Israel 98 97 91 16.1 17.3 15.0 6.2 7.2 73 3.0 0.. 16.6 3.6Ivory Coast n.a. n. n..n.e. 7.7/b 0.0. o. 11.0 a 2.0 nm .. 00Jordan .a 0.0. i.0 1.6 - 0.0. 9.8 10.0 262 2.8 0..n.a. 0.0.

Ko-e n.a.sc .. 1.3 9.0 c.. .2 - 63 2.7 n.. 0.2 ..a.NalYa n.. 109/h 97/k 0.3 2.8 4 .5 6.2 3.1 n.a. 10.7 46.MeXina 107 96- 76- 6.6 - 4.0 7.5 1.7 8 3.1 80 12.5 1.8H-rO-s 87 94 96 5.9 0.9 6.5 0.9 - 02.7 LO. . nomio.avgu0 113 136 85 10.0 1.5 3.0 9.6 2.1 n..3.5 12.6 2.8 0.8

Nigeria 97 11-1 99 5.1 6.3 4.8 10.9 6.7 34 2.0 0.a. 0 00Pakistan 4170 108 1207 - 0.3 2.0 3.1 9.5 36 2.2 1.4 3.2 0.2Peo -n... 113 93 8.6 8.3 3.5 7.5 1.7 11 2.9 6.7 12.9 3.0Philippines 109 106 92 5.1/g 5.5/g 3.6/1 2.5 1.1 13 3.3 5.9 11.9 2.3Senegal n.a. 0.. eo.. 9.87E 0.0. e. 6.3/b. n... 5o/c 2.3 n.. ea .0.

Spain 1.13 102 105 5.0 7.2 8.0 6.6 3.8 11 G.M .. a. 2.0 0.2S.ds.o n.a. 113 106 5.6 3.2 6.5 7.7 5.8 1 2.8 3.7 2.0 0.5Tajan 0.0a. 0.0. 0.. 6.0 9.9 6.0 6.7 11.0 39 3.0 0.6 0.9 0.1Talganyiha0.. 100 86 6.9 5.5 3.0 1.6 - n 1.8 o .a. n.a. 00Thailand /96 103 1017 3.9 6.0 2.0 3.6 6.3 10 3.1 0.5 i.4 0.2

Togo 4.. 00. 00 .7 1.8 0..9.6 6.6 50/d 4~.07 0.0.a00.cTunisia 5.0. 0.0. n.0. 3.1 0.2 4.5 1.6 0.0 50- 2.1 .. a. 0.6Turkey0.. .. n.a. 3.4 1.5 2.3 3.4 2.7 6 2.9 1.9 5.8U.A.R. 151 99 100 - 3.5 6.5 0 8/g 6.6/f 8 I 2.7 6.4. ..a.T.g.sl.vie 0.. 00. 00 .5 13.6 8.0-10.0/. 9.3- il.4 7 1.3 2.0 1.8

Sam notes -an footnotes on f.1llcuing page.

Notes to Table 10: Scc Data Bearing on Creditirthiness over the Medium and _o cn rooteson

Seneral: The period 'Fifties' generally refers to 1950-1°60, except for come countries where data for 1961 'a Average 1955 a-d 1958.and 1962 were available and for export and import val,e data whtre t most caaes the years 1948 acd 1949 wereincluded. The period 'Recent Years' is a. average of the list four or fie available years. /b Sour"e I9RD Report.

1. Changes in Terms of Trade are measured by annual indices ;4ith 1958=lG0. Two year averages are used. /c Crude estimate from IBiRD Report based on 1959 investment data and 1961 trade deficit.Figures in brackets are rough estimates. The average As-an Sterliri,cosntries import price isdex is usedfor Barma. Average import price index for Latin America is used for Erazil ond Bolivia. /d Crude estimate for 1958 based on data in IBRD Report.Source - IMF published and unpublished data, for M4excbo data ib draws from National Bank of Foreign Trade,and for some Far East counirias estimates prepared by IBRD. /e Tentative estimate.

2. Growth in Expert and Import Values (merchandise only) is in terms of a compoand rate per year. Base and /f Fublished figures underestimate the actual ibport values, especially in recent years. Allwmng foeterminal periods are generally three year aserages. Projected growtt} in export value is based on fiSt this, growth rate mav be 2.0f for Fifties and 9% for Recent years.economic reports.Source - IKF: Intcrnational Financial Statistics. For some Far East countries estimates prepared by /g The growth rates for export values do not take account of identifiable unrecorded shipments andIBRD. services. If these are allowed for, the respective rates would be 4.1% for Fifties, 6.3% for

Rescnt Years and 2.6% for Projected.3. Resource Gap is measured by the current account deficit (excluding factor income and Private DI...tioss as

a % of Gross Investment. Averages for the last four or five years are shows. Countries having current /h May be affected by hee- imports in 1949. Imports incrmased by 8% p.a. between first and secondaccount surplusea are marked .; this does not rue out occasional deficts. Net factor income -ap ents pisnrriods.abroad are excluded partly because the concept includes reinvested profits and pertly because the data tarnon a legal definition of "national" and "lforeign". However, there may be a good case for insluding them in /k Indices are based on the average of period 1952-60.calculating the Resource lap, in sore cases. Similarly, where private r-mittacecs and donations are regularitens, there may be a case for taking them into consioeratios. /r Refers to late 1950's; Resource .ap diminished in 1961 and 1962.Source - UN Yearbook of National Accounts and/or IBRD Reports.For India - Central Statistical Organization. _ = negative.

4. Growth in population is in terms of compound rates per annum. n.e. not available.Source - IBRD Reports.

5. Investment Income Payments as % of external ear.ings i.e. Current Account Receipts arc averages for 1950-1952 a,d 1959-1960. Investment Income Payments as % of GNP refer to payments in 1959-1960 and INP in15-1960. GNP figures are adjusted for gross under or over valuation of national currencies. InvestmentIncome Payments oonform to the IMF balance of payments definition t.e. they include total interest paymentsand dividends and profits, whetber re-invested or not.Source - IXF: Balance of Payments Yearbook (various issues).

6

- 62a -

TabLe la: Exports as a Pro tion of Gross Domestic Product

Exports as Population as Exports as aa percentage a percentage percentage of

of gross of the popula- the exportS ofdomestic tion of all devel- all developingproduct oping countries countries

(1) (2) (3)

india 5,7 30.8 453

PakistJan 6.9 6.5 1.3Brazi:L 7.3 5.1 4.55Mvexico 14.2 2.5 2.7Nigei a 13.7 2.4 1.6Philippines 10.5 2.0 1.8Thailand l6c1 1.9 1.5Turkey 7.9 1.9 1.1Korea 19.4 147 .1Burma 5.2 1,5 .8Argentina 11.9 1.4 3,4Ethionia 9M8 1.4 .3Colombiia 16.0 1.0 1.5Sudan 17.9 .8 .6Ceylon 30.0 .7 1.3Chinn (Triican) 12.6 .7 .6Peru 24.3 .7 1.5NilnyI )0.2 .6 3.0Rhodesia & Nyasaland 42.8 .6 1.9Chile 14 T6 .5 1.7Venezuela 32.5 .5 8.1CTGhan 190 °Ecuador 17.3 .3 .5GuatenM.l 19. R 4El Salvador 23.4 .2 .4Costa Uica 22.5 1 .3Honduras 20.6 .1 .2Israel 1~h 3=1 .7

Panama 27.0 1 .1Paraguay 1o.8 .1 .1

- 62b -

Table lOa: Exports as a ProDortion of Gross Domestic Product - contd.

Nqotes: 1. Percentages in Column (1) are exports of goods and servicesin 1960-61 or 1959-60 as a proportion of gross domesticproduct at current market prices in the same period except inthe following cases:

India: exports of goods and services in 1959-60as a percentage of net domestic product in195.9-60.

ilexico: exports of g,oods and services in 1960-61n.-; a zorron±.ns of Prnss natjinnal nrno]int.in 1960-61.

iePria: mmorts of cxonn ard serv.ices in 1957 as

a percentage of gross domestic product in195L7-

Ethiopia: exports of gcods and services in 1959 as

that year.Peru: lfL i gu r e s rec Ua- te to 1959 1 ony.

Figbures for domestic andl nationall prod'u-tion are bkase K- . '1± KKiIlK 0VS K- SIt. 10 Z -VOS '3KUK GIK-1 CID' 0(10K-L '.)

data from U. J., Yearbook of lNational Accounts Statistics,17GU,L a nd' _ DI ., re.ort[s.Figures for exports are from the U.I!. document and IM4FBaaiar'ce of Pavnervbs.

2. ropulation i-iLUre5 are uma ues for rid-1962 ±1llm U.ij.,Ponulation and Vital Statistics Report, data availableas of july 1, 1963 (Statistical P.c apers, S'erieS A, Vol. XV,NJo. 3).

3. Percentages in Column (3) relate to merchandise exports inyears 1960 and 1961 and are based on data in INF, Inter-national Financial Statistics.

4. In certain cases dollar value of exports had to be con-verted into local currency. This has been done at theaverage exchange rate for the year shown in INIF, Inter-national Financial Statistics.

cT4AYP UT fI GrtThfTTTQ IM\TRCKA.~)T .i C.IIUiN

135. T- -s studyr has att-ted to pro-ld de nn anal 1--iA e- frrnmywork fory ~L -4 - t - .LS- -- fl- -- ---

the cliscussion of problems of debt servicing capacity of the developingcountries, which are the major ....... iona+ l Torrmm-rQ +nroda IW.hi.le t.heframework can be applied to any one case, we have concentrated on study-ing clebt se-vicing problems of a hy-pothetical primay producing. ccutrywhich has a reasonably ambitious income growth target; which relieson forei loas a convenion tes for fnancin a considerableportion of its investment program; wlhich has a relatively closed economyandu canrint rapiUly ex-pand ltbs exports of' prU1imaryco;m-oie-b U_IgIIUu VIs V1

"light" manufactures clue to world market conditions,

136. Any borrowing on conventional terms results in a return flow ofinterest and amortization in fairly rapid succession. in t'he case offoreign borrowing, debt service payments are a charge on domestic realincomne and savings. These payments have to be transf-erred abroad eitherby expanding exports, by curtailing imports, or by further borrowingabroad. Capital inflows, and particularly exports of primary producingcoun-tries are fluctuating. On the other hand, debt service on publicand private loans is contractually fixed.

137. Inflexible obligations are potentially dangerous under anycircumstances. This danger was present even in the classical sys;1em offoreign investment in earlier centuries of economic and finarncial history,The ummitigated violence of the international business cycle, at thattime, frequently created havoc in international investmentc There -ere,however, two redeeming features0 Foreign private direct investmentprobably accounted then for a major share of total flow, and it wasconcentrated largely in activities producing primary products for exports:and as export sales fluctuated, so did profits in the export industries.The other redeeming feature was the complex inter-relationship of interes+rates, risk premia and the anticipated behavior of debtors in per-iods ofcrisis. It was expected that borrowing governments would defaultoccasionally on their fixed-term loans, when a depression reduced exportsand budgetary income or when budgetary policies were highly questionable.To offset this, debtors were charged an interest rate which included arisk premium high enough for the lenders to feel that chances of repaymentwere even or better than even. Probably the risk premium also includedan insurance against wars and international inflations. Who was -thewinner in this game, played by cred:Ltors and debtors, we do not know.What is relevant for this study is the fact that a mechanism to cope withfluctuations did exist and in its ow*m way it helped to accomplish themajor function of international investment: transfer of resources fromcountries with plentiful supply of capital and correspondingly low ratesof interest to countries needing capital and ready to pay higher :-atesof interest.

138. The prescnt situation is different from that described above.A major part of private direct investment still flows to exportindustries in less developed countries, although the products that aredeveloped are new: instead of tea, cocoa and rubber plantations, foreigncapital now finances aluminum smelters, iron ore mines, and above all,oil fields. The return flow of profits from these "enclave" investmen-tsfluctuate pari passu with export sales. But another part of foreigndirect investment in the developing countries now goes into industriesthat produce goods to replace imports, be it fertilizer or steel.The nrofit rnte in thes initistries is 'high enmcuph to offset the heavyrisks accompanying foreign investment and still yield a surplus abovewhat can be earned in the major firancinl renters of the world- Sales ofthese goods on the domestic market are rising rapidly and steadily. Sincefluctvuations in sales are minor, profits also terd to shw a uninntprrutin.dupward trend. A large part of profits, is reinvested in productive assetsand therefore serves to expand further the productive hbase nf thr oron,yor

But the share of profits that is not reinvested becomes a charge whichIdoes not varyin1pos to e-ort PI - tu + ior

A Thr~, n-v.e a' is obnenne-s l-l-lustratiLon of a r+ CLI wi r m Most rI

developing countries now consider the acceleration of economic growth a_ _ _. __ _L ~ 1 __ _~ - - - - 1 __ L-___ ._ _- - 14|4A.4 _fmilaJo tas fcing uthe. presenbt gen era fti d . Growth11 btarge dare aUmbitiousU

compared to resources that can be mobilized domestically for financingln-vestm,ent needed to achieve tvhese argeUs. The re'o'- ofgovernments in promoting more investment and faster growth are probabl;ygreater today than they were, on the average, in earlier periods ofeconomic history. Therefore, there is demand for massive capital inflowfrom abroad, and the major channels through which this inflow is trans-ferred are governments in developing countries, which either borrow ontheir own account or guarantee loans made to private parties. To theextent that this capital inflow occurs on "hard" terms, a rigid block isbuilt into their economic systems, consisting of contractually fixed debtservice obligations. And as capital inflow proceeds, these contractuallyfixed obligations also increase. True, the debtors are in a much betterposition today than in earlier periods, because they are now charged lessthan 6 per cent for "hard" money and even less for some other forms ofcapital transfers. The lenders, or more accurately, their governmentshave assumed the risk of default. A new concept of international financialmorality has developed. Debtors should not default, precisely because theyare charged moderate rates of interest and sometimes no interest at all0Nevertheless, the debt service charges do increase over time, since capitalflows are expanding.

140. The percentage share of exports absorbed by debt service willrise under any circumstances. However, if world demand for primary pro-ducts rises only moderately; if possibilities to expand exports of lightmanufactures are circumscribed by restrictions resulting from concern withdomestic employment in the importing countries; and if it takes tine todevelop competitive exports of heavy industrial goods, it is virtuallyinevitable that the ratio of debt service to exports will increase qui3klyand will attain a high level. This rigidity of the balance of paymentswill be further aggravated by a likely shift in the composition of imports

of the industrializing country, as purchases of raw materials, fuels, ,pareparts, and som.etimes even basic foodstuff's, rise rapidly. In short, i:'the return of capital, borrowed and domestic, is maximized by concentratingon activities catering to the domestic market, economic growth andstructural change of' the economy will be accompanied by increasedrigidity in external accounts.

141. We do not know how long it takes a developing country to over-come the worst phase of the strains on its balance of payments. Inparticular, we do not know at what speed an industry which has been builtinitially to supply the domestic needs, can be made sufficiently competi-tive to penetrate the international market. There are industrializingcountries which have accomplished the transition from domestic to exportorientation swiftly, in about a decade or so. It is impossible to sayhow representative or accidental their experience is. Sooner or later,if economic growth is a success, the structural change of' the economywill inevitably lead to a s-tructural change in external accounts, with aconsequen-t rapid rise in exports and the relaxation of' rigidities. Butin the meantimRe and for the foreseeable future. debt service as aproportion of exports wjill 'be very high and the sensitivity of theeconomy to declines in its canncitv to import will be very great. Underthese conditions, even minor fluctuations in exports and minor policyerrors of the borrower may have major repercussions

10)2. The prohe o T rigidities and fluctuations and of financ,i4danger that they imply, are only one aspect ci the debt servicingcapaciCityd of ~ the ~ de couint ries.~ F'rom, the' lnc , poinrt of

view, there are three other factors, that are of fundamental importance.First, the rate oi' retun on pro jects must be higher than the inter-national rate of interest. Otherwise, no basis exists for successful

servicing of fo g cil o cor.venti-onal terr.s. y,savings out of newly-generated income must be sui'fficient to enabletLih LLUI1r,,- to finance an increasing proporutlo of ±, UWLI UIVestm,nt

requirements out of domestic resources. At some point of time, aggregatedo..estic s3Vings must, exceed agggreate dom J.estic L.veJn My 3 0, rg

that is suf'iciently large to meet at least interest charges on thepreviously incurred debt.* If that point is never reached, funds woul`have to be continuously borrowed and indebtedness would have to increasecontinuouscly j-ust to meet interest; and as new borrowings would alsocarry interest, the debtor would be caught in the familiar trap of thecomripound interest law. Debt service wouid tend to reach the limit inwhich it is equal to national income. Thirdly, the total flow ofinvestmertt projects in the economy must be sufficient to yieia anincrease in aggregate national output at a rate in excess of populationgrowth. Otherwise, it may be presumed that the popular pressures wouldinterfere with debt servicing; and also, the flow of domestic savingsis unlikely to expand sufficiently unless aggregate real income risesreasonably f'ast.

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143. The developed countries have three choices in financing the economicgrowth of the developing countries. First, tthey may decide that in scmra countriesday-to-day financial dangers are so serous (para. 140) and the long-termprospects for growth so uncertain (para. 1h2), that the only safe way out isto provide most of the needed funds on "soft" terms. This device is, ofcourse, already being employed on a large scale (including the disposit.ion ofsurplus food-stuffs on concessionary terms), although there is some tendlencyfor countries that have made extensive use of this device to harden up theirterms, partly because otlher leading capital-exporting countries have con1tinuedto provide development assistance whollv cr predominantly on a "hard" basis.If "soft" funds cannot be mobilized adequately, and if it is thought that itwould be risky to expand "hard" lending, the second choice is to put arbitraryceilings on the flow of funds that are made available to countries where thesituation looks precarious. Denending on -were the ceilings are fixed, theconsequence may be that a number of profitable projects would not be under-taken because of the lack of finnnce, and the actual rate of economic growthin many developing countries may fall short of the technically and economicallyfeasibTh rTate The third choice is to try 1,ito live wxith thpe dnngers and withthe risks and to finance growth predominantly at "hard" terms.

144. In practice, of course, all three alternatives are present. The mLixturehas raried and will continne to vrary, depending on the judgIm.nt of the circim-stances of particular countries and on the actual availability of "soft" funds.For analytical prposes, however, it might be usefl to state, insome;hat moreformal terms, the conditions which would have to be met for the mechanism ofi.n+trnational lendilng6 at+. "hard"1 teMmlS to -V!Ork resnbySuccessfully. hassumption is that no arbitrary ceilings on lending are set and that allprojectso wlose yieldi exc~eeds, withA a resoabeduIu± m-in. ~4, the I1~ intrnt .Aional I ct

of interest (say, 6%) are financed.

145. The conditions are as follows:

(a) Financial

(i) The creditors agree to lend continuously despite high debtservice ratios (very high in some countries) and despite the generalrigidities in the balance of payments of their debtors. The length of theperiod of lending depends on how far particular debtors are from the point of"self-sustained" growth. Self-sustained growth is defined to mean a rate ofincome increase of, say, 5% p.a., financed out of domestically generated fundsand out of foreign capital which flows into the country because it wants todo so (investment is irresistibly attractive);

(ii) The debtors manage their external accounts in a way whLchenables tihem to pay their bills as they iall due, no questions asked;

(iii) The fluctuations in epori-t. i,-'rnimnq of t+, rehe debtrorq arefurther moderated, thus facilitating the fulfillment of conditions (i) and(ii );

(iv) Some way is found to solve the "cash squeeze" problem ofthose countries which have to repay an extremely large proportion of theirdebt, over the next few years. For the solution to be lasting a number ofvery difficult issues would have to be satisfactorily handled.

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(b) Growth

(v) The return on capital is higher than the inter-nati~onal ratep rof' lnterest;

(, ' The Ib-bac rof.i` proit is rhi rh ennrugh so that at

some point, however distant, domestically generated savings exceeddomestic ie n require±ents and t-hus lteavc a su. llus an be

used to meet service payments; and

(vii) The number of investment projects that are -under-tdaKen acIU th1atu miieetL thle condUUtIiLon (v) Ls sufLcentIL LIU enabiule LIlthLU La

output to grow at a "satisfactory" rate. A reasonably high incomegrowunvtl rate will also help in meeting the conditilon kVI.

]L6. hne condition (i) -- readiness of lenrders to provide feLndscontinuously and for a fairly long time despite liquidity dangers --has already been discussed. The only point which may be added is thatas time goes on, gross capital exports would have to become very largeif they are to yield a net addition to resources of the borrowingcountry. Such net addition takces place only when gross borrowing is inexcess of repayments and in excess of interest due on the debt alreadyoutstanding. And since new; borrowing also carries interest, the out-standingc debt compounds and this in turn increases the debt service thatis due. The practical implicat.ion is that in many countries themechanism of "hard" lending could not work properly unless at somepoint a substantial part of capital exports were put on a non-projectbasis.

i47. The condition (ii) is in the hands of the debtors, Difficul-ties in servicing debts have always been experienced, and they i!1rillcontinue to be experienced, whether we deal with debts of individuals,corporations or governents, and wliether debts are domestic or inter-national. The probleml which concerns us here is how such difficultiescan be reduced to a minimum. The massive transfer of resources fromthe rich to the poor countries which will have to last decades and whichis needed to enable the developing countries to create the basis forself-sustained growth, could not be undertaken on a "hard" loan 'oasisunless the paramount condition of any loan is respected: loans h'Aaveto be serviced, no matter what. lIoreover, all other bills - for imports,services, etc. - must be paid on time as well. Cnly if this is done,can the bankers in good conscience rnobilize capital from savers in therich countries and send it to distant lands. Cnly then can they lookwith leniency at the rigidities in the balance of payments structuresof their debtors and at the risks that these rigidities entail. IJnlessconfidence is created that bills do get paid on time, the lenders wouldhave to nharote a rate of interest vhnch would incornorate a pre.m-ilim torcover the risks. Such en interest rate might be much higher than thenT jorritv of debtors would be able to able toaffonz- Ever mnrei 1kel,r t;herequired flow of ca ital woulld simply not take place.

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J24U. Ihe task 0o. manid-l-ls the~ Ud±l e of pU d1jALlLd1int a11 ci vt .loptni

country is formidable. It is so because effective demand within thecountry is great - in-vestment activity is hligh1 and accelerating. Thisdoes not mean that maintaining a desirable rate of economic orowthnecessarily conf'licts with balance of payments equiiibrium. Casesstill exist where the propulsive force in economic growth is expansionof expcrts and where conservative fiscal and monetary policies arethe best policies to pursue. 'olitically courageous policies can extractthrough taxation resources needed for development, and it is also possible,to resist the termptation to f'inance fixed investment with short-termcredit. Where these circumstances do not prevail - and thlis appliesto a large number of the developing countries - it will be necessary toattempt to insulate the balance of payments from domestic inflationarypressures. In any case, the limits within which governments of thedeveloping countries, which are heavily indebted abroad, can act havebecome very narrow and the tolerances very fine. If creditors are askedto live with liquidity dangers, the debtors should be asked to exerciserestraint and act courageously.

149. Neither lenders nor borrowqers, will be fully able to handle theliquidity problems unless export earnings of the developing countricsattain some measure of stability (condition iii). It is true that theinternational business cycle today is something quite diff'erent than itused to be. Violent downswings in prices and quantities, so t,pical ofearlier international financial history, have been absent in the twodecades since the end of the war, and there is no present indicationthat they will recur. Occasional downward fluctuations in exportearning;s of' the less developed countries, however, still occur. viuchadvance has been made in mitigating the impact of these f'luctuations,both bv the actions of the International Iionetarv f'und ana by nubliclending agencies of the industrialized countries. But it is generallyagreed that thle nrnbler.m is st ll with us andj that, mcii-h remains to bedone.

150. Even if condi-tions (i), (ii) and (iii) are met, the process of'"hard"n lending ca-nnot be exprected on ! large scale in countries whoseexisting debt structure is extremiely unf'avorable, until some solution tot.heir liniiirli+ ir ntroblem is found (Condition iv). Tn several ntrie

which are large international debtors, pending payments are extremely high.No sou1 tiioin orff n-r present liquidity probler is likely to prove llst.ing,however, unless advance is made in coping with the root causes of thepresent+ di fficf r'l + Q d LvA J + may 1- + hat developmentalA ret t

capital in some of these "cash-squeeze" countries are high despiteinadequate finarcial policies; but th ese inetmn opp i*uii a-tbe explcAited unless the VC~ uii UjjjU1 UlLiqu- crb is resolUv

be exploited unless thae liquidity crisis is resolved.

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151O From the long-run point of view, the developmental returns aredecisive. If there are countries in which these returns, properlyestimated to include both the direct and indirect benefits, are below theinternational rate of interest, it does not make sense to transfer capitalto these countries on conventional terms (condition v). We do not knowwhether such cases exist, but it is quite possible that among the 100countries currently engaged in the developmental process there are somewhere natural obstacles and lack of skills are such as to keep the rate ofreturn below the rate of interest, at least for some time to come. If itis considered that these countries ought to be helped to develop, it wculdseem that lending to them on "soft" terms is the only solution.

152. It is not sufficient, however, that the rate of return on individualprojects be in excess of the international rate of interest to justifylending at "hard" terms. The plough-back out of increased income must besufficiently high to make it possible for the country to reach a stage inwhich it can pay out of its own resources for all its investment that isneeded to attain a satisfactory rate of growth (vi). This condition - themarginal savings rate sufficiently above the average savings rate - car. bemet only if fiscal and monetary policy is conducive to generation of publicsavings and if private entrepnreneurs are ontimistic enough to plough-backa large proportion of their profits into domestic activities rather than ininvesting abroad. The achievement of a su]fficiePntl.y high snvinps rate: isthe sole responsibility of the borrowing country. Here creditors cannotnrovi de mii-ch hp.n Tf t+.iy hanro a bhais for iuidamPrt- t.hat. donmestiesavings wi.:Ll not equal domestic investment requirements in the foreseeablefuturej ho.m.ever distant, lending on "hardl" terms cannot do the job.Whether creditors, under these conditions, want to help the country by

account whatever objective obstacles stand in the way of progress of thebo rnr, Uin colt,i

'.. ' ere are counrJtes whilnere lh.et1 present V S t i Le i vr ji

population extre.nely large and natural resources limited in relation tcp opula L.iLol. I.,L t,hese casb, ret Ul on pcUtuLILdLU1V ULs ma iy Utbe ig

and the p:Lough-back of profits generated by these investments may be large,nd jet eiit aggrega te rate oUf saViL1O rI, 4- II11 LU 1GW. If, despi+e bein

low, the aggregate rate of savings is increasing gradually, it is possibleUild.u US.11dUti UUIA=Ut _ ULO 0CVJ_1It'Z WJ.-L- t:2LkAt,U .U IV tz: ULLItai U. ILIlt U.UIit. OjJ.JCL1

may, however, be extremely long and consequently, the gross capitalI _ rn _ _ - 1_ _ __: ln n __ __ _- - 1 - . - 1l I - _ _- v : _1___ - - _ - _1 I X-- r .inflow lab Will ue nleeueu, anlu tne idluelbedless whichLcl WOU1U res;iUlt flr Ull

financing the country predominantly on hard terms, may be extremely high..'ulese are so-called "long-haul" countries. We hope that they are few,but they may be very important in relation to the total population of thedeveloping countries.

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154. For growth in income and in savings to materialize, there shouldbe a sizeable number of invest...ent projects started yearly /onndition(vii'7/. In other words, the aggregate investment rate must be at asuffi.ciently high level. IJnless thi.- is nnnrnplished the whole processmay never "get off the ground", beca.use population growth mJy continuallybe catchina un withl inenme arno.th= T- ic primarily the ripnsl hi ii-iof the debtor country to develop profitable projects, but the incustria-lizecl countripq .an pnrovide help which Tnay prove derisive.

155. The suzcessful growth-cum-debt process unlti.rftely depends cn eo-variables: the size of the investment activity which a developingc.ol]nft.rV y scrI in ,he rtin ,¢, th! rate of ret- n-in ier,.+en,-4- +t,h

rate of plough-baclc of the increment, in income generated by the newinve:,tm nt, and t.lr,er-atlJona1 rat e 0of lnte-est charged on borrowed-"- ~A' -_ -1" -aS L ~ L CL L LI UL

loan capital. It is a matter of policy which one of these variables*., 1-3 hcliosn1 a' a. +ar;lo poic ac o. _Lr so_ T. __me_ _.--- P a _ v ui a U.' UIUiI. ±11 -_UIIft UVtelUpL1lg uuwI Ur.±et

it will suffice to raise the absorptive capacity and thus attain a. higherrate of investr:ent cornsisti.ng of high -ielding- projects. In all of thei,it is necessary to attain a high rate of plough-back, and thus rai-se theaverage rate of savings wih-Iich1 is the ultimnate deterrU'nant ol self--sustained and independent national economic growth. ind for some of

lthem the interilti ratL e of interest - that key variable in theprocess of 7rowth-cum-debt - will have to g;ive in if The internationalnvest v ent systemi is to function with tolerable smoothness.

156, The policy questions which are posed by this study are serious.They are whether full interest will be charged ever-ywhere, how the pre-sent liouidtit- crises in several countries can be successfully overcomeso t.iat the growth orocess can be resumed and, perhaps above all, howthe absorptive capacity for high-yielding projects can be increased.It nay be very difficult to find a solution to these issues, and, inany case, they probably require the concerted effort of both lendersand borrowers on a scale and in harmony, whiich would be withoutprecedent. But -the tasl, itself, i, also without precedent.

157. This study has not solved the debt servicing probler:.s, nor hasit succeeded in identifying one or a few statistical indicators whichwould conclusively show that the iimlits of indebtedness at conventionalternis have been reached. flather, it has arrived at a negative conclusionthat such indicators probably do not exist. The study has developed,however, an analytical franmework which nay be of some help. By uSingthe methodology suggested in the study it is possible, by aCtachingvalues to different factors, to arrive at a picture, however hazy, ofhow external indebtedness of particular countries might grow over time.The choice of values deDends on existing quantitative knowledge and,above all, on judgments regarding the future. These judgments arenecessarily subjective in character,

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