4.7 Role of International Debt Data Response (2)

Posted by: Evangel on: February 24, 2012

• In: Articles | Section 5: Development Economics
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Question 1: Distinguish between ‘internal’ and ‘external’ debt.

An internal debt is owed by a nation to its own citizens, while an external debt is owed by a nation to non-residents.

Question 2: Using examples from the article and from your own knowledge, examine the problems associated with a developing country having a significant amount of external debt.

• There is increasing inflation. The article states, “The country’s, inflation has steadily increased from 14.1 per cent in April to 16.0 per cent according to the May data released recently. At the same time, food inflation has increased from 39.3 per cent to 44.1 per cent while energy, fuel and other utilities grew from 8.9 per cent to about 9.1 per cent.”
• Increased interest rates meant that the debt that needed to be serviced increased. The article states, “debts have pushed domestic interest rates to a higher end and the cost of debt servicing is going up by the day, leaving insufficient funds for basic services provision including for education, healthcare, safe drinking water and infrastructural and energy projects.”
• The recession in the developed world meant that they imported less from developing economies, since there has been a long-term decline in the real value of most commodities.
• Net capital inflows reducing dramatically.
• Debt-export ratio rising meaning developing countries having to earn more money from the sale of exports just to pay their debts.
• Debt to GDP ratio rising as a larger proportion of their national income is debt.
• Debt-service ratio rising. This shows the percentage of export revenue that has to be used to repay debt plus interest. This is not a problem if exports are rising faster in real terms, but they were not.
• Interest as well as the capital sum has to be repaid. Failure to repay debts causes a loss of financial status, which can have an adverse effect on future foreign investment flows.
• Slender financial resources are used to pay debts and not to build schools, hospitals etc. so there is a substantial opportunity cost involved. The article states, “More resources will be committed to debt servicing rather than investment and welfare of Ugandans.”
• Borrowing continues in the developing countries. The article states, “In Uganda, the minds of politicians go to sleep with borrowing. No one feels tasked enough to solve the country’s problems. Whenever there is a problem, the answer is borrowing… In Uganda, the problem is that even when we borrow, money is either abused or remains unspent yet we pay commitment fees.”

Question 3: Explain how inflation affects the external debt of a country such as Uganda.

There are two types of inflation: cost-push inflation and demand-pull inflation. Cost-push inflation, often called stagflation, is inflation that is caused by an increase in the costs of production in an economy that shifts the short-run aggregate supply curve to the left. The cost-push inflation is detrimental to any economy, since there is loss in efficiency and thus in output, while there is inflation. Demand-pull inflation is inflation that is caused by increasing aggregate demand in an economy that shifts the aggregate demand curve to the right. Assuming that a developing country, such as Uganda, is going through demand-pull inflation, the inflation is good for the developing country in the long-run, according to the Keynesian model, because as aggregate demand increases, the output (i.e. real GDP) increases, which means that the country is growing economically. Therefore, the developing country, in theory, should be able to pay its external debts and not experience the debt cycle. Nevertheless, inflation has negative impacts to a developing country in the short-run because inflation brings up the interest rate. Higher interest rate means that the country has to pay more money to repay the debt. This may lead the developing country into poverty cycle because the government will increase the allocation of its capital to a higher percentage to repay the debt. This means that the government needs to reduce their spending on other aspects, such as education and health care. Reduction in government expenditure in education and health care is harmful to a developing country in the long-run because if the citizens are not educated well or are in bad health, they cannot work efficiently. Hence, the economy of developing country will not be able to grow.

Question 4: Evaluate the policies that a developing country, such as Zambia, can use to counter the effects of inflation.

There are several policies—both fiscal and monetary—a developing country, such as Zambia, can use to counter the negative effects of inflation. Assuming that the inflation is demand-pull, the country can shift the aggregate demand curve back to the right through fiscal policy (such as decrease in government expenditure, decrease in net exports, and decrease in consumption) to decrease inflation. However, this is not a smart idea because rightward shift in aggregate demand of a developing country means that it is unlikely to grow. Less government expenditure, especially in areas such as education and health care, will be harmful in the long-run because if the citizens are not educated well or are in bad health, they cannot work efficiently. Therefore, it is better for the developing country to solve its debt rather than decreasing the inflation. The best way to do so is to expand GDP faster than their debt ratio. Nonetheless, trying to bring about significant economic growth in the short-run is very hard to achieve in practice. Second way to deal with the debt is to have its debt re-scheduled; here the terms of the debt are renegotiated so the developing country has a longer period to repay the loans and interest. Third option is to ask the richer nations to write-off debts. This would help the developing economy to import more and hence boost developed world trade. Such imports could raise living standards and allow for more investment. A further option is debt swaps, where a creditor country cancels a debt at its nominal value. In return, the debtor invests part of the cancelled amount in development projects according to conditions previously agreed by both parties. UNICEF’s Debt for Child Relief is an example. The last option is beneficial to both the rich nation and the developing nation because the developing nation gets a cut in debt while the rich nation receives the money they have lent to the developing nation in different means. In conclusion, the developing country should gear more towards stabilizing its debt rather than focusing on reducing inflation.