World Bank Reprint Series: Number 399 Marcelo Selowsky and Herman G. van der Tak The Debt Prolblenm and Growth Reprinted with permission from World DevEelopment, vol. 14, no. 9 (September 1986), pp. 1107-I124, published by Pergamon Journals Ltd., Oxford, United Kingdom. World Developnmetnt, Vol. 14, No. 9, pp. 1107-1124, 1986. 0305-750X/86 $3.0() + 0.00 Printed in Great Britain. © 1986 Pergamon Journals Ltd. The Debt Problem and Growth MARCELO SELOWSKY and HERMAN G. VAN DER TAK* The World Bank, Washington, D.C. Summary. - Easing the debt problem requires high-debt countries to generate significant trade and savings surpluses. If this has to be achieved quickly these surpluses can only be built up through contractive measures withl lower imports and investment. Alternatively, if more time is available to deal with the problem, these surpluses can be built up, without sacrificing growth, through increases in exports and savings. This strategy will require new financing on the part of creditors until adjustment measures take effect. Debtor countries, for their part, will have to significantly improve their domestic performance. Domestic savings and exports will have to grow at fast rates. The productivity of capital and efficiency of resource use will also have to improve significantly. The paper provides a simple quantitative framework that identifies the critical values of these variables required for a successful outcome of a growth-oriented debt policy. 1. INTRODIJCTION ditions for its success - in particular the respec- tive roles of external and domestic efforts and the The high-debt countries have been servicing way they interact as time passes - have not been their debt largely by austerity measures. They made fully transparent in recent discussions. To have squeezed imports and investments to gener- do so is the purpose of this paper. ate the trade surpluses (and equivalent savings surpluses) necessary to finance the debt service, but at a high cost in terms of foregone consump- 2. THE MECHANICS OF ADJUSTMENT tion and output. Without access to significant new lending to provide time for expanding The outcome of a growth-oriented debt policy exports and savings, they had little choice but to hinges critically on the rate of growth of domestic contract. savings (that is, gross domestic product minus Table 1 shows what has happened in recent total consumption). For debt ultimately to de- years in 17 high-debt countries. Current account cline, in relation to GDP and absolutely, savings balances have, on average, become approxi- should increase faster than the sum of investment mately zero in the absence of significant net and interest payments on the foreign debt. To capital flows. Trade balances have sharply im- generate the required rate of increase in savings, proved, but largely by a major reduction in it is necessary to constrain consumption below imports rather than an increase in exports. Lower the growth in GDP. In many countries, especi- imports have affected short-run output and con- ally those with modest population growth, sumption. Consequently, GDP has stagnated savings can rise sufficiently fast with constant, and consumption per head has fallen. Investment or even slowly rising consumption per head. has also shrunk, severely restraining future Growth and rapidly rising savings will, after some growth. years, ease the debt burden. But in the early Countries are unlikely to continue along this years of recovery, the country will need to path for the sake of servicing their foreign debt borrow more, in addition to rolling over its and reducing its long-run burden to a reasonable existing debt. Below we shall consider in more level. Belt tightening alone is not an acceptable detail the total net borrowing required under solution, economically, socially or politically. Easing the debt problem through growth is a *We are indebted to David Lebow for research more promising alternative. This has become assistance and to our Bank colleagues, in particular increasingly recognized, for example, in the Frank Lysy, for useful comments. The views presented Baker initiative. But the mechanics of such here are the authors' and do not necessarily reflect the adjustment through growth and the critical con- views and opinions of the World Bank. 1107 1108 WORLD DEVELOPMENT Table 1. Seventeen high debtors: Macroeconiomnic indicators 1978-81 1984 1. As a percent of GDP Trade balance -1.5 4.2 Current account balance -3.7 -(.1 2. Average annual growth rate between 1980 atnd 1984 GDP -0.3 Exports 1.8 Imports -9.2 Investment -9.7 Consumption per capita -1.8 Source: World Bank. Countries included are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Cote d'Ivoire, Ecuador, Ivory Coast, Jamaica, Mexico, Morocco, Nigeria, Peru, Philippines, Uruguay, Venezuela. Yugoslavia. various scenarios, and the time it takes to reach also the interest payments on the foreign debt crucial turning points in the recovery process. As rD, where D is the outstanding (real) debt and r would be expected, key factors to emerge will be the average (real) interest rate. Assuming as a the desired rate of consumption growth, the first step r constant, then the change in interest population growth rate, the efficiency of invest- payments over time depends on the change in the ment, the initial savings rate, and the (real) rate outstanding debt, that is, net borrowing, over of interest on foreign debt. and above rolling over of amortization of the The analysis starts with the selection of a existing debt. Net borrowing will be necessary as "reasonable" growth rate of GDP, g. Together long as savings are insufficient to cover the sum with an estimate of the incremental capital- of investment and foreign interest payments: output ratio, ICOR, which should reflect a S < I + rD. In other words, net borrowing judgment on the average efficiency of invest- becomes B = rD + I - S, which is also ment, this determines also the required invest- equivalent to the current account-deficit (defined ment rate IIG = g * ICOR. The efficiency of here as positive).2'3 investment is likely to change over time. For ease As long as the country is a net borrower, its of exposition, we assume initially that the ICOR total debt will continue to grow. A useful remains constant. In that case, the growth rate of reference point is that when net borrowing equals investment equals, of course, the growth rate of interest payments, the rate of growth of debt GDP. equals the rate of interest. The growth rate of What happens to savings depends on the debt will be higher (lower) than the interest rate change in consumption. The more consumption if net borrowing is larger (smaller) than interest is allowed to rise, the less will be the increase in payments on the foreign debt. savings. As a starting point, assume it is socially In many cases, domestic savings do not even and politically acceptable to maintain consump- cover investments, let alone interest payments on tion per head constant, so that aggregate con- the foreign debt. Net borrowing will have to sumption grows at the same rate as population. finance both interest payments on the existing Given the growth rate of GDP and the initial debt and part of investment; and debt will then savings rate, s = SIG, the change in savings over grow at a rate exceeding the rate of interest. With time can then be determined.' As long as savings growing substantially faster than invest- aggregate consumption growth is kept below the ment, as they will when consumption growth is growth of GDP, savings will grow faster than constrained significalntly below that of GDP, at GDP, and thus than investment (when the ICOR some point domestic savings will equal invest- is assumed constant). The savings rate will then ment (or equivalently, the trade balance will incr-.ase. become zero, X -M = 0). Net borrowing will However (domestic) savings are necessary to then be necessary only to finance the foreign finance not only the required investments but interest payments, and debt (and interest pay- THE DEBT PROBLEM AND GROWTIH 11(9 ments) will at that point grow more slowly, at the shown. The lower panel shows the major flow rate of interest r. With a growing excess of magnitudes. The domestic savings rate starts savings over investments (or equivalently, a below the "required" investmenit rate, but is growing trade surplus), net borrowing necessary assumed to increase rapidly througlh a conistraint to finance interest payments will decline, and on consumption. As long as the resource require- debt will grow at a rate less than the rate of ments R, that is, the sum of investments and interest. At some point the rate of growtlh in the interest payments on the foreignl debt, are above foreign debt (and interest paymenits) will fall to g, savings, net borrowing is required to sustain the the rate of growth of GDP, and debt will begin to growth rate of G)DP. Net borrowing declines as decrease in relation to GDP. Still later, domestic time passes because the rate of growth of savings savings will grow to cover both investmernts and is set higher than the rate of growth of resource foreign interest payments (that is, the current requirements. Notice, however, that the debt/ account becomes zero, I + rD - S = M + r) - GDP ratio (and thus interest payments as a X = 0) and debt will begin to decline absolutely. fraction of GDP) starts declining while net In brief, the growth of debt, and of the interest borrowing- is still positive, but small enough to burden, will steadily decline and ultimately be- result in a percentage increase in debt smaller come negative as long as our basic assumption than the growth in GDP. holds which constrainis the increase in consump- Figure 1 distinguishes all the stages described tion below that of GDP and investment. Ilow- earlier: ever, the process takes time and substantial net Stage 1: Up to T,, when savings are still borrowing is likely to be required before debt below investmenit, borrowing is begins to decline. such that the rate of growth of There is a further complication. The adjust- debt, and of interest payments, is ment process requires that a domestic savings larger than the (average) interest shortfall, with respect to investment, is trans- rate. formed into an adequate savings surplus. Or. Sttage 2: At 7' , savings equal investment, equivalently,.as noted above, that a trade deficit and exports equal imports. Net is transformed into an adequate trade surplus borrowing is equal to ii1terest (I - S = M - X). Without the trade surplus payments. Debt andt interest pay- there will be no savings surplus, and vice versa. ments grow at a rate equal to the Growth in GDP is likely to require additional average interest rate. imports. If imports are not forthcoming, growth Stage 3a: From T7, to Tb, savings are large of GDP will be less (that is, the ICOR will rise). enough to finance a fraction of As a first approximation, assume that the value interest payments. Debt and of imports needs to increase paripassu with GDP interest payments grow at a rate and therefore, with a constant I('OR, as fast as below the interest rate but above investment. The value of exports will have to the rate of growth of GDP. grow much more rapidly. If the expansion of Stage 3b: At T11, net borrowing is such that exports involves a worsening in the terms of debt and interest payments grow trade, then the volume of exports needs to at the same rate as GDP, and the increase even more (and the savings effort will interest payments/GDP and debt/ need to be that much greater). If the elasticity of GDP ratios reach their maximum imports, with respect to GDP, is greater than level. one, as is often the case, exports will need to Stage 3c: Between Tb and Tt, net oorrow- increase even faster. If they do not, the trade ing diminishes further, so that surplus, and therefore the savings surplus, will debt and interest payments grow not rise as rapidly as derived above. Export at a slower rate than (GDP, and performance and savings behavior have to be decline as a fraction of GDP. consistent for the recovery from the debt prob- Stage 3d: From T(. on, net borrowing be- lem to progress smoothly. comes negative, that is, savings finance n0ot only interest pay- ments but also part of the 3. A GRAPHICAL ILLUSTRATION amortization. Debt and interest payments decline in absolute This debt recovery process is illustrated by terms. At year T*, the debt/GDP Figure 1, where all variables are in real terms and ratio has declined to a "normal" expressed as a fraction of GDP. In the upper level where the countrv is con- panel, the behavior of the debtlGDP ratio is sidered creditworthy. 111() WORLD DEVELOPMENT Magnitudes as a Fraction of GDP iqual to g Below g. but Posiive (D/G)3 , II I i (D/G) = Creditworthiness , I I I , K I T (S/G) Savings Rate Curr.ent Account Surplus "Rasource Requirement Line": (,nvestment plus intereJt payments) (rD/j0 ' Dtici Ne //r~Iu / 7/, RIG =I IG + rDIG -tT /~r .'. .,- . (VG) g * ICOR = Investment Rate S/c-,f - Time 0 Ta Tb Tc World Bank-30245:1 Figure 1. This pattern of recovery from a debt crisis will them will vary over time and are influenced by hold generalh true, provided savings grow suffi- government policy. Below we show the results of cientlv faster than investments (or exports than simulations with different sets of parameters. imports). But the time it takes a country to reach the turning points identified above, and the antount of net horrowing required before debt begins to declinie relatively or absolutely, will 4. NUMERICAL ANALYSIS vary greatly depending on the particular circum- stances of the country. The initial debt overhang; As base case, we assume the following set of the average rate of interest on the foreign debt; parameters: the efficiency of resource use, as reflected in the (a) Target growth rate in GDP in constant ICOR; the minimum acceptable growth in con- dollars, g = 0.04. sumption; the elasticity of imports with respect to (b) Initial domestic savings rate = 0.15. output; the extent to which net borrowing can be (c) Target growth rate of aggregate con- obtained, are key factors in this regard. Most of sumption, in constant dollars = 0.02. If THE DEBT PROBLEM AND GROWTH 1111 this rate is above the population growth (a) Base case under constant real interest rates rate, this implies an annual increase in Table 2 shows the external balance from the consumption per capita. If it is below initial year to the year where (real) interest the population growth rate, it implies a payments again decline to an "acceptable" level, decline in consumption per capita. arbitrarily set at 4.0% of GDP, where the (d) Incremental capital output ratio country is again considered "creditworthy." (ICOR) = 4. Given g = 0.04, this When the country starts with interest payments implies a required investment rata of equal to 5% of GDP (Type A), it takes 8 years to (1.16. reach this new level. When initial interest pay- (e) Average real interest rates paid on the ments are 8% of GDP (Type B), it takes 13 foreign debt. Two alternative assump- years. Notice - as was illustrated in Figure 1 - tions: (i) average real interest rates that the savings balance steadilv improves and remain constant at 8% a year; (ii) they net borrowing steadily declines as a percentage of decline to 7% after the initial year, to GDP, but interest payments (and debt) as a 6%" by the following year, and remain at fraction of GDP first increase, reaching a max- that level thereafter. imum in the third and fourth years, respectively. Tables 2 and 3 show results for the base case, In other words, some creditworthiness indicators assuming constant and declining real interest worsen in the short run, before starting to rates, respectively. In each case, results are improve. shown for two types of countries. In Type A, On the base case assumptions, the recovery initial real interest payments as a fraction of path would require substantial net borrowing, GD)P are (1.05. It characterizes countries like totaling nearly 15% of GDP in Type A countries, Mexico, Argentina. Venezuela, Philippines, and and more than 30% in Type B countries. If Brazil, with initial debt/GDP ratios in the 0.60- borrowing on this scale is not feasible, the (0.7(1 range. In Type B, the "debt overhang" is country will need to follow another recovery much larger, and initial real interest payments as path, for example by further increasing the a fraction of GDP are 0.08. It characterizes savings rate or lowering investment requirements countries like Chile, Jamaica, and Ivory Coast, or seeking lower interest payments. with initial debt/GDP ratios of about 1.00.4 The columns of Tables 2 and 3 show the (b) Base case under declining real interest rates following derived variables, all expressed as a Interest rates payable on foreign debt may be fraction of GDP: lower, on average, for several reasons. Inter- ('olumn 1: Required investment rate, given g national interest rates may decline and affect the = 0.04 and ICOR = 4. variable interest component of outstanding debt; ('Colunn 2: Domestic savings rate, resulting inflation may reduce its fixed interest compo- from g = (0.04 and aggregate nent; countries may obtain more concessionary consumption growth rate = 0.02. rates, on additional borrowing or in connection (Columnn 3: Savings surplus (or trade bal- with debt rescheduling; or they may benefit from ance), which is negative when more grants or cancellation of debt. Our alterna- savings are below required invest- tive base case assumes that for a combination of ment and positive when savings such reasons the average real interest on existing are higher than required invest- debt paid by the prototype countries declines ment. from 8 to 6% over 2 years, and remains constant ('olumtns 4 Real interest payments; they in- thereafter. and 6: crease by an amount equal to net Table 3 shows the results. As would be borrowing the year before multi- expected, lower interest rates reduce both the plied by the interest rate, plus aggregate amount and the period of n't borrow- (the increase) or minus (the de- ing required. In fact, if the interest (decline is cline) in interest payments on large, in relation to the percentage increase in existing debt due to changes in debt in the preceding year, the (real) interest interest rates, if any, all in real burden as a fraction of GDP will immediately terms. decline, as in Table 3, because the "declining (Colunns 5 Real net borrowing, i.e., the in- interest rate effect" more than compensates the and 7: crease in the real stock of debt, "additional debt effect." Nevertheless, total net equal to the interest payments borrowing required remains substantial. But it plus (minus) the domestic savings now takes less time for the country to become deficit (surplus), all in real "creditworthy" again. With declining interest terms.5 rates, interest payments in Type A countries 1112 WORLD DEVELOPMENT Table 2. Base case: External balance under a constanit real interest rate of 8% (values as a percentage of GDP) Type A T'ype B Medium level High level of initial debt of initial debt Required Resulting Real Real investment savings Savings interest Real net interest Real net rate rate surplus payments borrowing payments borrowing Year (1) (2) (3)=(2)-(1) (4) (5)=(4)- 3) (6) (7)=(0)-(3) () 16 15. - 1.( 5.0 6.0 8.1) 9.( 1 16 16.6 0.6 (Ta,) 5.3 4.7 8.4 7.8 2 16 18.2 2.2 5.4 3.2 8.7 6.5 3 16 19.8 3.8 5.5 (Tb) 1.7 8.8 5.0 4 16 21.4 5.4 5.4 (T) 0 8.9 (Tb) 3.5 5 16 22.9 6.9 5.2 -1.7 8.8 1.9 6 16 24.3 8.3 4.8 --3.5 8.6 (IT.) 0.3 7 16 25.8 9.8 4.4 -5.4 8.3 -1.5 8 16 27.2 11.2 3.8 (T*) -7.4 7.9 -3.3 9 16 28.6 12.6 3.1 -9.5 7.3 -5.3 1() 16 31).0 14.0 2.2 -11.8 6.6 -7.4 11 16 31.3 15.3 5.8 -9.5 12 16 32.7 16.7 4.8 -11.9 13 16 34.1) 18.() 3.8 (T*) -14.3 14 16 35.2 19.2 2.5 -16.7 Assumptions: g = 0.(04 Initial (DIG) ratio: ICOR 4 rype A 0(.6S25 A(7C = 0.0)2 Type B 1.(). r 110.118. Table 3. Base case: External balance under a declining real initerest rate (values as a percenlage of GDP) Type A Type B Medium level High level of initial debt of initial debt Required Resulting Real Real investment savings Savings interest Real net interest Real net rate rate surplus payments borrowing payments borrowing, Year (1) (2) (3)=(2)-(1) (4) (5)=(4)-(3) (6) (7)=(6)-(3) 0 16 15.1) - 1.() 5.0 6.0 8.0 9.0 1 16 16.6 11.6 4.6 4.0 7.3 6.7 2 16 18.2 2.2 4.1 1.8 6.4 4.2 3 16 19.8 3.8 4.1 (T,) 0.2 6.4 2.6 4 16 21.4 5.4 3.8 (T*) -1.6 6.3 (T,) 0.9 5 16 22.9 6.9 3.6 -3.3 6.1 -(1.8 6 16 24.3 8.3 3.3 -5.() 5.9 -2.4 7 16 25.8 9.8 2.9 -6.9 5.5 -4.3 8 16 27.2 11.2 5.1) -6.2 9 16 28.6 12.6 4.5 -8.1 1() 16 30.0 14.1) 3.8 (T-) -1(0.2 11 16 31.3 15.3 3.1 -12.2 12 16 32.7 16.7 2.3 -14.4 Assumptions: g = 0.1)4 Initial (DIG) ratio: ICO'R = 4 Type A = 0.625 AC/C = (0.0)2 Type B = 1.0. r = 0.08, (.0)7, (1.06 0.0)6, . . THE DEBT PROBLEM ANI) GROWTH 1113 drop below 4% of GDP in 4 years, as compared Tablc 4. Required annual raite J ogrowth to 8 years when interest rates are constant (Table of exports (10-Year average percentage) 2).' For Type B countries, it takes 1() instead of 13 years. A more severe test of creditworthiness, Import Initial stiare reducing (real) interest payments on foreign debt elasticitv of exports in GDI' to 3%4 of GDP, would take a few years longer (also shown in Table 3). X/(; = (1.15 X(- (0.25 (.8 1 1.() 8.4 (c) ('onsumlption inplications 1.() 11.4 9.1 All these scenarios assume that aggregate 1.2 11.9 9.5 consumption growth is constrained to 2(,% a year. For most countries, this means at best constant consumption per head, and for manv countries, with population growth rates exceeding 2%',, pot-ods.) It shows that the average annual growth declining consumption per head. For the high- rate of exports7 is substantially greater when the debt countries (Type B), this consumption con- initial share of exports in (GDP is small. This straint or decline would have to be maintained suggests that countries that are large or less open for over a decade, if this recovery path were to trade face a more difficult task. This is further followed. Even for the medium-deht countries, aggravated if countries depend heavily on im- austerity would last nearly a decade, unless ports of equipment and intermediate inputs for average interest rates on the foreign debt came their growth in GDIP and have little room for down. efficient import substitution, so that their import It is doubtful that countries would be able or elasticity will not be significantly lower than one. willing to keep consumption down for such long If exports do not grow fast enough to generate periods. A more likelv, and more sensible, the necessary export (and savings) surpluses, approach would be to relax the consumption then the particular a(djustment process is not constraints somewhat after recovery had pro- feasible. To be consistent with the poorer export ceeded to the point, T'_ where net borrowing performance. savings will rise less than antici- becomes negative, that is., debt declines absolute- pated, either through higher consumptioni or Iv. or possibly even earlier, at point T,b, where slower growth of GI)P. In the first case, borrow- net borrowing begins to decline as a proportion ing requirements and the time taken to recover of DP.. T'his would shorten, or with declining creditworthiness may increase substantially. In interest rates possibly eliminate, the period of the second, borrowing requirements will be less extreme austerity, but at the cost of a loniger (unless the ICOR rises), but at the cost of lower period before the debt is reduced to an accept- consumption levels in the long run. The following able level 7'. section on sens;itivity analysis further explores some of these relationships. (d) Erport requirements C(olumn 3 of T able 3 shows that countries have to generatte a razpidly rising export surplus (that 5. SENSITIVITY ANALYSIS is, savings surplus) in order to sustain the recovery paths discussed azbove. T'he rate of (a) .S'ensitivit v to changes in lite tari'et growth rate increase in exports that is required will be of (iI)I and I'(R greater, the larger is the initial trade dleficit. the Table 5 shows for medium-debt overhang rise in imports wlhen DI)P grows, anld the (Type A) countries the sensitivity of borrowing deterioration in the terms of trade associated requirements to alternative specifications of the with [he uxlansion of exports, and the smaller is target growth rate of GDP and the value of the initial value of exports in relation to GI)P. ICOR. The results can also be interpreted 'Fable 4 illustrates the export performance differently. They show the maximum growth rate required of a Type B couniitrv. under the declin- that can be achieved under alterniative availabil- ing interest rate assumption. to reach credit- itvofforeign finance, given that countries will be worthiness in 10 years. (The improvement in the makintg, a savings effort compatible with a con- savings, that is, trade balance follows the same sumption growth of 2" a vear. The bottonm line path for the different scenarios in Tables 2 and 3, shows the number of years it will take countries and is determined by the growth of GDP,? to lower their (real) interest payments on foreign investment requirements, and the growth in debt from the initial figure of 5%l, of GDIP to 4"% consumption, but to reach creditwor-thiness the of G)DP, the level taken above as a proxv for imnprovement has to be sustained for different "creditworthiness;" it also shows this for a more 1114 WORLD DEVELOPMENT Table 5. Required real net borrowinig: Sensitivity to the target growth rate and ICOR: Type A colt. tries (,nedil,n debt overhang) (values as percemitage of GDP) ICOR -4 I('OR = 5 Growth rate Growth Rate of GDP (%) of GDP ("%) Year 3 4 5 3 4 5 (base case) 0 2.0 6.0 10.0 5. 10.0 15.() 1 (.6 4.0 7.4 3.8 8.2 12.7 2 - 1. 1.8 4.6 2.4 6.3 10.2 3 -1.9 (0.2 2.3 1.6 4.9 8.' 4 -3.0 -1.6 (.8 3.4 6.2 5 -4.0 -3.3 -2.3 -0.1 1.9 4.1 6 -5.0 -4.8 - 1.0 0.4 4.1 7 -6.9 -7.3 -1.9 -1.2 -(1.2 8 -9.8 -2.9 -2.9 -2.4 9 -4.0 -4.6 -4.8 10 -5.0 -6.4 -7.1 1 1 -8.3 -9.6 12 -12.01 No. of years it takes intere!st pavments to become 4%N. of GDP (T*) 2 4 6 6 9 I() 3"% of GDP 5 7 8 It) 11 12 Assumptions: AC/C - 0.02 r (.0)8, 0).t)7, 0.), 0.06. . . . severe test of creditworthiness, 3%/0 of GDP. As quired in the short run to achieve a 5%i annual will be seen, the "turning points" where debt GDP growth could be forthcominlg. If the pro- begins to decline or creditworthiness is reached ductivity of capital is lower, ICOR = 5, even a are only moderately sensitive to changes in the 4% GDP growth does not appear feasible. growth rate of GDP or in ICOR. But the net Countries in this situation can at best achieve a borrowing requirements are quite sensitive. 3%X GDP growth, unless average real interest As expected, the "recovery of creditworlthi- rates payable by them experience further and ness" with low capital inflows can only be strong reductions. achieved with low GDP growth. This is probably what characterizes the present situation. To (b) Sensitivitv to alternative rates ofconsiunption achieve "creditworthiness" with a higher growth growstlh rate requires substantially higher capital inflows, Table 7 compares the borrowing requirements although only for a few years. Table 5 shiows the for the base case - where consumption was results to be highly sensitive to the values of assumed to increase at 2X% a year - with an ICOR, that is, the inverse of the productivity of alternative assumption where consumption is capital. A 25%' lower productivity of capital allowed to grow at 3% a year. This might be a implies a substantially darker picture. Not only necessary condition for a country with a popula- do capital inflows have to be substantially larger, tion growth rate above 290R. The most important more than double in many cases, they also must effect of relaxing the consumption constraint is to continue for longer periods of time. The number lengthen the period where net borrowing is of years required for the country to reach the necessary. Net borrowing requiremelnts do not assumed proxy for "creditworthiness" also in- increase significantly in the first 3 years. How- creases significantly. ever, with the higher consumption growth, net Table 6 shows results for the high-debtor borrowing is needed for an extra 3 years in Type countries (Type B). Even with an ICOR = 4, it is A countries, and an extra 5 years in Type B difficult to expect that the capital inflows re- countries. The number of years required for the THE DEBT PROBLEM AND GROWTH 1115 Table 6. Required teal tnet borrowing: Sensitivitv to the tieti,et growth rate anid ICOR: Type B countries (hiighi debt overhang) (value.s as percenltage of GDP) ICOR = 4 I(COR 5 Growth rate Growth Rate of GDP (") of (Dl)P (0) Year 3 4 5 3 4 5 (base case) 0 5.0 9.0 13.0 8.() 13.0) 18.(0 1 3.3 6.7 1().1 6.5 11.0 15.4 1 I.5 4.2 6.9 4.8 8.7 12.5 3 (1.6 2.6 4.7 4.1 7.3 10.6 4 -0.4 (1.9 2.4 3.4 5.9 8.6 5 -1.3 -(1.8 ().1 2.6 4.5 6.6 6 -2.4 -2.4 -2.3 1.8 3.1) 4.4 7 -3.4 -4.3 -4.8 (1.9 1.4 2.3 8 -4.6 -6.2 -7.3 () -(1.2 (1.1 9 -5.7 -8.1 -9.9 - 1.) -1.9 -2.2 10 -7.(1 -1(0.2 12.6 -2.1 -3.6 -4.6 11 -3.1) -5.4 -7.01 12 -4.1 -7.3 -9.4 13 -5.2 -9.2 -12.0 14 -6.4 -11.2 -14.5 15 -7.6 16 17 18 19 No. of years it takes for interest payments to become 4A", ol (Gl)P (T*) . () I() 1( 15 14 14 Assumptions: A C' I (1.0)2 r (1.1)X. (1.117. )0.(6, (1.16.. interest payments to reach an assumed "credit- long periods below acceptable levels, or the worthiness" level of 3 or 4%" of GDP inmreases average interest burden needs to be effectively substantially, particularly for countries with a reduced further. high debt overhang. (c) Itnferasible adjustmnentpat/h 6. CII0ICE OF GROWTi AND T he foregoing exercises suggest that regaining CONSUMPTION PATHI creditworthiness will he difficult to the extent that consumption growth cannot be restrained, (a) (;roo'tlz Jtercreditort bittessisrestored the ICOR is high, exports cannot be rapidly Up to this point the analysis has focused on expanded or imports compressed, and the aver- various scenarios for recovering creditworthi- age rate of interest on foreign debt is high. This ness, here defined as reducing the (real) foreign mayn well apply. for example, to some countries interest paviments/GDI)P ratio to a "reasonabie' in Africa, except that their borrowing terms are level, assumed to be 4"% or less of GI)DP. As rather soft. Rapid population growth puts press- shown, this requires in all cases a sharp increase ure on aggregate con.;umption growth. Export in the domestic savings rate, typically to betweeni prospects are often dim, and import dependence 21) and .30",, of GDIP, and thus a severe constraint to sustain arowth of output is large. I(CORs are, on consumption increases beloNw the rate of and have been, rising. In such circumstances the growth of GDIP. What happens when credit- design of an adjustment path mal face a di- worthiness is restored'? lemma: consumption has to be restrained for Once interest payments on the foreign debt, in 1116 WORLD DEVEIOPMEN T Tfable 7. Require'd rel edc hntorroitlng: S'ensitivil'i to growthl ra-t'et ofconsumlption (valta'.S as ptrc'entag(e of (GDP) fype A countries Tyvpe 13 countries (medlium debt overhatng) (high debt overhanrg) Growth ol' consumption (irowth ot consumptioin Year 2"k,, 3`1 2R 3% (base caise) (base case) () 6.0 6.0 9.() 9.1( I 4.o 4.8 6.7 7.5 1.8 3.4 4.2 5.9 0(.2 2.7 2.6 5.1 4 -- 1.6 1.9 (.9 4.4 5 -.33 1.1 -0(.8 3.6 6 -.() m0.2 -2.4 2.8 7-- 6. -0.7 -4.3 1.9 8 -1.7 -- '.2 1. 9 -2.7 -8.1 (1 1 I0) -3.7 -1(1.2 -(0.9 I 12.2 --1.9 12 --3.0 1 3 -4.1 1 4 -5.2 15 --6.4 16 -7.7 17 -9.1) No. of wears it takes I'or interest pamnents to becomne 4", of' )D (' 1' 4 7 10 15 3% * (;L)p' 1 0 11 17 AssumInpt ions1: g. (((( 1(01R 4 r - 01.08X ().0-,, ().00,(.( .. ..6 relation to (G)D1, have been reduced to their implies the debt/GDPI ratio is kept constant at creditworthiness level. they can be allowed to 0.633. If the country chooses to continue GDP rise in line with the growth in G[)P. The interest growth at 4(% (with ICOR = 4 as before) the pavmentlGDP ratio will then remain constant, rnquired investment rate will remain at 16%/o of and with a constant interest rate, so will the ratios GDP. With the debt/GDP ratio constant, the net of debt to GDP and net borrowing to (;I)P. borrowing/GDP ratio will also be constant: Interest payments, total debt, and net borrowing will then all grow at the same rate as GDP. BiGDP = g(DGDl)P) = 0.04 x 0.633 = 0.025. Instead of repaying debt, the country can become a net borrower again. The required savings rate drops from 30), in year What about savings and consumption? With 10 when creditworthiness is reached, to 17.3%, the shift from debt repayment to net borrowing, since BICG = IIG + rDtG - SIG, that is 2.5 = 16 the domestic savings required to sustain (,0P + 3.8 - 17.3. The consumption rate correspon- growth will sharplv decline, and consumnption can dingly jumps up from 70 to 82.7%. After this be allowed to rise substantially. After this once- large adjustment, both savings and consumption for-all change, they will both grow at the rate of grow at the same rate as GDP. growth of GDI'. To illustrate, consider a Type B hIowever, the country could choose another country that reaches creditworthiness after 10 strategy and accelerate its growth of GDP, say to years of austerity, when interest payments are 5%, a year, when creditworthine>s is reached. reduced to 3.8%, of GDP (see Table 3). At that This is illustrated in Figure 2. Faster growth of point it resumes net borrowing, such that rD)IG is CDP does not affect the creditworthiness condi- maintained at 0.038. With r constant at 6%, this tion, rD/C = 0,038, or, as long as r = 6`. the THE DEBT PROBLEM AND GROWTH 11i7 Asa Percentage of GDP 30% - 25% ; Investment t Intesrest Palyments 1Investment - Interest Payments d Repoym35nltz ;,, 23.8% -K,,1tin-ejest P'ayments Net Borrow^ing =3 2% Ne . . ... .....a 20.6% 20% Borro.ing0% 8 V38% Investmentl 0 1S 2if 1 1 1 3 1 1 6 1 8er rwthe e: st Payments 5%- 3.8°b- Value Consistent with "Creditworthiness" I II § I l 1 A I . I I 0 1 2 3 4 5 6 7 8 9 10 I11 12 13 14 15 16 1 7 18 Years i - 4% Growth Regime: Adjustment 4 - -* 5% Growth Regime- Steady State World Bank-30245 2 Figure 2. Type B countries. Evolution to a new equiilibritim. Movliig fron a GJDP growli ofJ 4%i, to 51"O after creditworthlinzess is reached. Consutzmptiotn growth in-reases from 2%0t (tluring thet adlju.stmlent period,I to 5"%' ini thie new steadv state (values as "' ! of GDP). debt/GDP ratio, which remains 0.633. But the 3 years -arlier than with a 5% grcwth strategy. required investment rate rises to 20%; of GDP. Thus it will be able to lower the savings rate and And net borrowing increases to BIGDP = 0.032. increase consumption earlier than under the high As a result, the required savings rate does not fall growth strategy. However, with the high growth as much as with continuation of the 4% growth strategy the country will reach a higher level of rate in GD? (to 20.6% rather than 17.3%6). And GDP and consumption in the long run. How can the upsurge in the consumption rate is correspon- these consumption flows be compared? dingly less (to 79.4% rather than 82.7%f), but Table 8 shows the index of aggregate consumo- consumption will now grow at 5% a year rather tion under three alternative strategies. Strategy 1 than 4%. So there is the usual tradeoff between starts with a 3% GDP growth and then switches more consumption now or later. to 5% growth 5 years later, when creditworthi- ness is reached. At this point, consumption (b) Co(mparing tilternzative growth pathls benefits from a once-for-all upward adjustment, This line of analvsis can also be used to assess as discussed above, and shifts from 2%0 to 5% the tradeoff between strategies of fast or slow growth. Strategy 2 starts with a 5% growth of growth from the start of the recovery process. GDP and maintains that rate throughout. Credit- For example, Table 5 (with ICOR = 4) shows worthiness is reached later than under Strat- that a Type A country which follows a 3% growth egy 1. At that time, lnet borrowing, investment strategy will reach creditworthiness (defined here and interest payments become the same constant as real interest payments equal to 3% of GDP) fraction of GDP under the two strategies, and so 1118 WORLD DEVELOPMENT Table 8. Coium/tptimni streamns withi alterlative growth pat/hs; Type A countries (index: Year ) = 100) Before cicdimi-orih,inw'N Path I ( o) Path 2 (2 ) Patli 3 (%o) ('onsumption differences (GDP growth: 3 5 5 Path 2 Path 2 Consumption growth: 2 2 3 minus minus Path I Path 3 After creditworthiness (;DP gr-owtlh: 5 5 5 Consumption growth: 5 s 5 Year ()1()().(1 1(()( 1(()()()( I 102.0) 10(2.() 103.0 () - 1. 2 ' 1()4.1( 10)4.( 1(16.1 () -2.1 3 106.1 10.1 1(09.3 1) -3.2 4 M108.2 108.2 112.6 ( -4.4 5 11(.6 (7*) 11(.3 3%sl 115.9 -0.3 -5.6 6 116.1 112.6 119.4 -3.5 -6.8 7 121.9 \J114.8 122.9 -7.1 -8.1 X 128.11 138.2 (IT) 126.7 +1(0.2 +11.5 9 134.3 145.2 130.5 + 1(1.9 + 14.7 1() 141.11 152.5 134.3 + 11.5 +18.2 11 148.1 16(0.0) 16(0.0) (T*) +11.9 () 1I2 5. 155.5 168.110 168.11 +12.5 () 1 3 163.3 170.5 176.5 + 13.2 '1 14 171. 185" 185.RIS3 +1I3.X ( 15 18(5.11 194.4 5%!, 194.4 + 14.4 () 1( 189.1) 2(04.2 20(4.2 + 15.2 (1 17 198.5 214.4 214.4 + 15.) () 18 20(8.5 225.2 225.2 + 16.7 () 1 9 <218.8 ,236.5 \,230.5 + 17.7 () Source: Table 4. with I()R - 4. Notes: Creditworthiness is assumned to he reaiched when real interest pavments hecome 3()", ot( GP)1. do savings and hence consumptioni. But with serviced, it is likely to increase the domestic cost Strategy 2, the absolute level of consumption will of generating the necessary foreign exchange, be higher, and the on 'e-for-all adjustment through pressure on the real exchange rate and greater, since GDPlihas been growing at a higher lower terms of trade. While a higher growth rate in the early years and consumption has been strategy is generally attractive, there are definite constrained longer. As a result, Strategy 1 limits to its feasibility and desirability, as current consumption is lhigher only during the few years debt problems have abundantly demonstrated. whenl creditworthiniess has been restored witlh Table 8 also shows the consumption path with this strategy but not yet with Strategy 2. But an alternative high growth strategy (Strategy 3). Strategy 2 consumption is higher for all subse- GDP grows again at 5%, throughout, but con- quenit years. sumption growth starts at 3"%, rather than 2% as UTnder any reasonable discount rate, these with Strategy 2. This requires more net borrow- results favor the higher growth strategy (Strategy ing and it takes several years longer for credit- 2), given the assumptions underlying Table 8Y worthiness to be reached (see Table 7). At that IHowever, a higher growth strategy from the start point, consumption is adjusted upward and then of recovery requires also substantially higher net grows pari passu with the 5%, growth rate of borrowing in the early years (see Table 5), which GDP. As a result, consumption with this strategy may not be forthcoming. Furthermore, a sharp is higher than with Strategy 2 in the Larly years. increase in investment may lower its returns, that But the high-savings Strategy 2 restores credit- is, raise the ICOR, thus reducing the benefits of a worthiness sooner, which allows an earlier boost highl growvth stratcgy. And additional borrowing in both the absolute level and the rate of growth may entail increasine costs because (a) it may in consumption. After a few more years, when raise interest rates on both the additional and Strategy 3 also achieves creditworthiness, con- existing debt and (b) when the debt has to be sumption levels and growth become the same TIlE I)EBT PROBLEM AND GROWTH 1119 with both strategies (as do GDP, debt, interest both interest payments and net borrowing re- paynment, etc.). So the only lasting difference is quirements exceed the corresponding real that Strategy 2 sacrifices consumption in the early amounts shown (as a fraction of GDP) in earlier years for a temporary gain later. tables by p(DIG) (see Appendix). Which strategy is preferable depends on the Table 9 compares real and nominal interest discount rate. A higher discount rate would favor payments and net borrowing requirements. It higher initial consumption (as in Strategy 3); a assumes a dollar inflation rate of 3% per lower discount rate would favor higher post- annum,' and uses the base case of declining real poned consumption (Strategy 2). The appro- interest rates (from 8 to 7% in the following year priate level of the discount rate is difficult to and 6% in all subsequent vears). The determine. But note that, if borrowing is ration- corresponding nominal interest rates i, therefore, al, it cannot be lower than the real rate of interest become 11. 10 and 9%. The resulting nominal on additionial foreign borrowing (or more pre- interest payments and net boirowing require- cisely, the marginal cost of borrowing). Note also ments are seen to be much higher than the that the ' political discount rate" is likely to be corresponding real magnitudes. For example, in high, to help ensure acceptability of adjustment the first year, both nominal interest payments policies and survival of the government. Thlis and net borrowing needs exceed their mav well swiilg the balance in favor of a corresponding real values by 1.9 and 3.0 percent- 'higher-ogrowth rising-consumption' path as in age points for Type A and B countries, Strategy 3. But this requires even higher net respectively." Nominal borrowing becomes borrowing, and for a longer period, than a policy 7.9%o of Gi)P in Type A countries and 12.0% in of high growth with low consumption (Strat- Type B countries. Cumulative borrowing needs eav 2). It is not feasible without sustained finan- are also substantially higher in nominal terms. In cial support from foreign lenders. Type A countries, an increase in the real stock of debt (in a 4-year period) equivalent to 12% of GDP, requires an increase in the nominal stock of debt equal to 19.9'%, of (GI)I'. In Type B 7. NOMINAL. INTE-REST BURDE.N ANI) countries, an increase in the real stock of debt (in NET BORROWINGC a 5-year period) equal to 23.4°% of (GD)P requires an increase in the nominal stock of debt of The preceding analysis has discussed the 39.. I. chainges in the real interest burdcn in relation to If one applies the previous yardstick that real GDP during the adjustment process. llence creditworthiness is "restored" once interest pay- all variables, (i1)l. investmnents, savings, the ments fall below 4%' of GDP to nominal rather interest rate and the stock of dlebt outstanding, than to real interest payments, one uses, of are expressed in real ternis. Consequently. net course, a tougher yardstick and the adjustment borrowing was defin(ed ats thec change in the rea1 period will be longer. For the case shown in stock o ,f debt. Table 9, an extra 4 years will be required for a Ilowever, interest payments anrd net borrow- Type A country, and an extra 2 years for a Type ing. as observed in the world, are not expressed B country. in real terms, but in nominal terms. Correspond- ing currenit account balances ats traditioIlaliy shown in national accounts are also in nominal terms. In order to translate our earlier estimates 8. PO(lCY IMPLICATIONS of real net borrowing to nominal amounts, it is necessary to add the borrowing required to hold The earlier analysis has identified the main the real stock of existing debt coinstaint. The size variables - and the way they interact as time of this adjustment will depend on the rate of passes - which determine the success of an inflation. adjustmeint program aimed at recovering T'he noilinlal interest rate i exceeds th.e real creditworthiness with growth. As expected, the rate of interest r by the rate of intlationi p. i.e., success of such a program depends on four sets of i= r p. 'I'he analysis in real terms incorpor- variables: the availability of net foreign financ- ated only the r componienit of the equation For ing, p;irticularlx in the short run: the possibility an analysis in nominal terms. it is necessary to of rapidly increasing the donmestic savings rate, include the p comnponent in the estimates of the possibility of rapidly generating an export interest payments that have to be financed, and surplus; and the possibility of increasing the hence of the current account deficit and net overall efficiency of resource use, that is, a borrowing required. In nonminal termls, therefore, decline in I('OR. 1120 WORLD DEVELOPMEN T Table 9. Comparison betwveetz real and tln2oin1al ilnterSt pa'tments aindl ieLt borrowving (bhas case ider dtecliniing real interest rates; values as perce(ntage of (GI)P)` Type A countries 1''pe B coountries Interest payments Net borroving Interest payments Net borrowing Year Real Nominal Real Nominal Real Nominal Real Nominal 1 5.0 6.9 6.0 7.9 8.(1 1] l. Qt) 12.1) 1 4.6 6.6 4.0 6.1) 7.3 111.5 6.7 9.9 2 4.1 6.1 1.8 3.8 6.4 9.6 4.2 7.4 3 4.1 6.1 ).2 2.2 6.4 9.6 2.6 5.8 4 3.8 (7*) 5.7 -1.6 (1.3 6.3 9.4 (.9 4.1) 5 3.6 5.4 -3.3 - 1.5 6.1 9.2 --0.8 2.3 6 3.3 4.9 --5.11 -3.4 5.9 8.7 --2.4 11.4 7 2.9 4.3 -6.9 -5.5 5.5 8.2 -4.3 -1.6 8 2.3 3.5 -8.9 -7.7 5.1) 7.5 --6.2 --3.7 9 4.5 6.7 - 8.1 --5.9, 1() 3.8 (Ti 5.8 1o.2 -8.2 11 3.1 4.7 12.2 -1(0.6 1 2, 2.3 3.5 --14.4 --13.2 Assumptions: g 11.104 ICOR 4 AC 01.0)2 -(.)8. (0.117. 11.06. 01.110.6 - i = (11. (.1() . 0.9) 0.9 . . . *Nomitlal values are expressed as a percentalge ol noninall (i)l' real Nalues are expressed as a percentage of real (G1)P. (a) NefJlowfs offoreignifitiintnce from 2(1 to 30)-% of G[)P. These increases will not Any program of adjustment compatible with a allow increases in per capita consumption for sustained "minimum" (GDP growth in the range periods that range from 5 to 12 vears unlless of 4%, a year will require significant net borrow- sufficient net-foreign financing is fo;rthcoming to ing as a percentage of (GDP, particularly in the support a highi growth/rising consumption path of short run. During the first 3 years of such a adjustment. program, these annual flows may be around Three policy issues arise: First, what system of -3--5((o of GDP, in real terms, tor countries with a incentives and policy reforms can sharply in- medium debt overhang (real interest payments crease private savings. Second, what is the most around 5%X. of GDP), and approximately 5-9%30/ efficient mix of policies to raise public savings: for countries where such overhang is arounid 8"%0 increase taxation, improve pricing of pLublic of GDP (corresponding nominal flows are even servicv's, and reduce government expenditure. larger). Further net borrowing is likely to be Third. what domestic borrowing policies are necessary in subsequent years. but on a declininig appropriate to help the public sector service its scale. Required annual borrowing is less if large part of the foreign debt. In most circum- interest rates fall, and greater if resource use is stances, a kex objective of these policies will be less efficient. Equally important, a policy of more to avoid preempting private savings and invest- rapid economic growth (and some relaxation of ment, particularly where the public sector has consumption constraints) which is likely to be become overextended. In most cases, a large part preferable and compatible with recovery of of additional puLblic savings will have to come creditworthiness in manv cases, is only feasible if about at the expense of government expendi- supported by even hiigher levels of net borr-owing tures. sustained over a number of years. A reduction of public expenditures will have to be accompanied by important reallocations (b) Domnesticsavings among expenditure items. Subsidies will have to Strong increases in domestic savings rates are be highly selective and targeted. Their objective required; they will have to reach values ranging should be to protect the poorest groups of the [IHE I)EBT PROBLEM AND cGROWTHi 1121 population (children?) from the possible cuts in key factor in generating the necessary responses their per catpitai consumption levels. (Government both from local producers and consumers, and investmiienit will have to concentrate on support from foreign lenders. for the expansion of exports and efficienit import As we have seen, the debtor countries can substitution. recover their creditworthiness with different growth rates of GDP. Lower growth will require (c) Exports suluJ1hs littie net borrowing and can restore creditworthi- As shiownI earlier, the export surplus will have ness rather quicklv, but at a high cost of to grow at the same pace as the savings surplus. permanently lower output and consumption. That surpllus increases bv increasing exports and This is clearlv not in the interest of the borrow- substituting imports. But it should not be ex- ers; it may not even be in the interest of the panded at any cost. 'Fo promote expansion of the creditors, if political problems associated with most efficient export and imFport competinig low growth increase the risk of debt repudiation. sectors, the increased scarcity of foreign ex- A higher growth of (GDP is probably preferable change in the econom0lvy shoulid be translated into as an adjustment path, but requires substantial (a) a higher market exchange rate, (b) a mlore net borrowing on a larger scale than currently in neutral trade regimiie that w-ould lhelp not only prospect, and delays the recovery of exports. bLut also the most efficient import creditworthiness. This will only be feasible if conmpetinig sectors, thalt is, thiose that need little creditors are willing to match a long-term protectioni other than this higlher exchange rate. commitment of debtor countries to policy re- For such policies of the debtor countries to be forms with adequate net lending. successful, it is important that thev be com- More definite conclusions on appropriate plemienited and supported by econoimic expan- recovery paths, and their net borrowing implica- sion and liberal trade policies in the creditor tions, can only be reached by calibrating the countries. general approach outlined here with specific country conditions. Some of the simplifying (d) 77w overall efficiencv of resource use assumptions made above will need to be carefully As discussed earlier. gzreater efficiency of considered and modified in that case. In particu- resource use will increase the productivitv of lar, as noted earlier, the IC'OR (the proxy for the additional investmenit and produce more output productivity of investment) and the cost of from existing resources, that is, lower the ICOR. borrowing are unlikely to be roughly constant, as This will clearly speed up the recoverv of assumed above, within the range of additional creditworthliniess for any given rate of consump- investment and borrowing being examined. The tion growtlh, or allow the aclhievemeniit of productivity of investment mav fall (the ICOR creditworthiness with lower consumption sacri- will rise) if the pace of investment is accelerated fices. This requires that both the private and the and meets absorptive capacity constraints of public sectors are guided bv signals and incen- various kinds. The country's cost of borrowing tives that better reflect the opportuniity costs of may go up with additional borrowing, if it drives resources and the benefits to society. up the interest rate the country otherwise has to pay, and/or the cost of generating foreign ex- (e) (.onclusions change when interest and repayment are due is The domestic policv reforms and adjustments larger than the benefits of additional dollars at required for recoverv of creditworthiness the time of borrowing. And finally, in judging the through growth 'ire well known. Most of them benefits and costs from a high investment/higlh would be desirable for sound development any- borrowing strategy, one should properly com- way, even without the debt problem. But the pare the marginal social productivity of invest- urgency of the reforms is now much greater. For ment, rather than the ICOR, with the marginal them to be successful, it is important that they be social cost of borrowing. This more selective sustained, and that they be perceived as per- measure of the productivity of investment further manent by nationals and creditors alike. More limits the range over which it is desirable to boost automatic policy instrunments that are less subject investment and growth. But these refinements to discretionary changes will help boost confid- and qualifications do not change the broad ence that the reforms are here to stay, which is a qualitative conclusions of this paper. NOTES 1. The relevant formulas are summarized in the 2. The definitions of net borrowing, current account Appendix. balance and interest payments used here differ from 1122 WORLD DEVELOPMENT' those conventionally used in the national accounts. Net 6. Note that declining interest rates restore the borrowing (and thus, the current account balance) is creditworthiness of Type A countries without any net defined here as the change in the real (not nominal) repayment of foreign debt (Table 3). stock of debt. The amount that has to be borrowed just to keep the real stock of debt constant is considered as 7. The improvement in the trade balance in Tables 2 part of the rollover of debt. This amount is equivalent and 3 implies a somewhat faster growth rate of exports to the part of nominal interest which matches the in the early years, tapering off later. inflation rate. Of course, the equivalent increase in the nominal stock of debt must include this inflation 8. The higher absolute debt with Strategy 2 (high component of interest payments. The effect of inflation growth) does not substantially change this conclusion. on nominal borrowing requirements is illustrated in Table 9 below and discussed in Section 7. A more 9. If this adjustment is not made, the real stock of formal analysis is presented in the Appendix. debt is declining because of inflation, and the country is, in effect, amortizing its debt to that extent. 3. This exposition ignores equity investment and capital flight, as well as other factor payments and 10. The relevant dollar inflation rate should include current transfers; it also ignores the possible need to only internationally traded goods. build up foreign exchange reserves. Suitable adjust- ments can easily be made to allow for these factors. 1P. With p = 0.0)3 and DIG (1.63 (Type A), p(DIG) = 1.9%, 4. Typical Type A countries have nominal interest With p = 0.03 and D'G = 1.0() (Type B), payments as a fraction of GNP in the 0.055 to 0.08 p(DIG) = 3.0(%,. range. For typical Type B countries, these interest payments are in the 0.09-0.13 range. 12. Since GDP is growing over the period, one should strictly not take the simple sum of the annual net 5. Nominal inte:est payments and nominal nct borrowing needs, where each year is expressed as a borrowing are larger to compensate for inflation. percentage of current year GDP. However, the distor- Corresponding estimates in nominal terms are dis- tion is small, and the substantive point remains. cussed in Section 7. APPENDIX 1. Thepihasesofthedebtburden by the gap between domestic savings, S. and the requirements to finance investment plus interest pay- The earlier discussion can be summarized specifying ments abroad, that is, the current account deficit (here the following set of relationships: defined positive). (a) A target GDP growth in conistant dollars, g, is set at a "predetermined" value. B - rl) + I S. (A3) (b) Assuming a constant incremental capital-output ratio, ICOR. the investment requirement (f) is Substituting (A3) into (A2): automatically determined. The required invest- ment rate becomes a constant and equal to: A (r)) - rAD - r rln) + I - S]. (A4) IIG = g -ICOR (Al) The growth rate ol interest payments and debt are equal (as long as r is constanit) and can be written as: where G= GDP. A(rD) - r A) = O) The economy starts with a given burden of interest rD) rD D) payments on foreign debt, rD, where r is the real dollar interest rate on existing debt and D the stock of debt in constant dollars. Assuming r remains constant, the r + (PG) - (SI/G), (AN) change in interest payments over time will depend on (D'G) the change in D, which is equal to the amount of net real borrowing, B - over and above rolling over of Expression (AS) is convenient because it allows the amortization. Thus the change in interest payments can rate of growth of interest payments (and debt) to be be written as: written in terms of the interest rate plus (minus) a "correction" factor.A" Thus, the interest rate can be A (rD) = rAD = rB. (A2) used as a reference point, as was done earlier. A decline in the debt/GDP or interest payments/GDP On the other hand, net borrowing will be determined ratio requires for the growth of debt to be lower than g. THE DEBT PROBLEM AND GROWTH 1123 Thus, if the interest rate is larger than g, the savings exceed real debt, interest payments and net borrowing rate will have to increase to a minimum critical value (the subscript N denotes nominal values): above the investment rate to achieve this result. Consequently, a necessarv condition to achieve a lower Real debt D - DNIP, (A9) debt/GDP ratio is to increase the savings rate, that is, savings must grow faster than GDP growth, g. where P is a dollar price index. Real net borrowing is Because the investment rate (IIG) is constant, defined as the change in real debt: expression (5) can be used to define the different phases of the adjustment process as the savings rate AD =AD/P - pDN/P, (AIO) increases, as shown in Figure 1.A2 Defining s = (SIG): N DebtfGDP where p = APIP is the rate of inflation. Phase Ratio I Nominal net borrowing is: Phase 1: si < IIG, so ADiD Increases Phase 2: S2 - I/G, so AD!D Increases AD> iDN + IN- SN, (All) - r >g Phase 3: si > IlG, such that Increases where i is the nominal interest rate. g < ADID < r Phase 4: S4 > IIG, such that Reaches its Hence AD SN -S+ i DN - D, (A12) g = AD/D < r maximum P P P Phase 5: s5 > JIG, such that Declines g > ADID < r orAD=I-S+rD (A13) Phase 6: s,, > JIG, such that Absolute ADID negative. debt declines where r = i - p. A necessary condition to tower the debt burden is an As a fraction of real GDP, G: increase in the savings rate. That increase can be written in terms of g and AC/C. the rate of growth of AD I - s + r D aggregate consumption. G G G As= ( - s) (g - AC/C). (A61 = increase in real debt as (A 14) a fraction of real GDP. Thus consumption must grow at a lower rate than But nominal net borrowing as a fraction of nominal GDP. If ACXC is set below population growth, con- ( do11 GDP G sumption per capita will be declinii;g, and vice versa. (urrent olars) , N. IS The trade surplus as a fraction of GDP can be written ADN I, - S + i __ as:NN GN GN GN X - M = s - I (A7) I- IS + i D (AI5) G G G G G where s is again the domestic savings rate.A" Because or AD, = AD + pD the investment rate is constant, the change in the Gv G G export ratio XIG can be written as: = increase in nominal debt as (A16) a fraction of current GDP. A(XIG) = As + (MIG) [E - 1Ig (A8) Thus, nominal net borrowing as a fraction of current where E is the elasticity of import requirements with GDP is equal to the change in real net borrowing (the respect to output. If this elasticity is larger than one, change in the real stock of debt) over real GDP plus the the export ratio will have to increase (in absolutc rate of inflation multiplied by the debt to GDP ratio. terms) faster than the required increase in the savinrgs Nominal interest payments in relation to nominal GDP rate. If it is equal to one, the export ratio increases at is: the same pace as the savings rate. Notice that, for a given value of A(XIG), the required growth rate of i. - D i D = rD + D. (A17) exports will have to be larger the smaller the initial G G G G share of exports in GDP. N Nominal interest payments as a fraction of nominal 2. Real and ntominal mragnitudes GDP equals real interest payments as a fraction of real GDP plus the rate of inflation multiplied by the debt to Nominal debt, interest payments and net borrowing GDP ratio. 1124 WORLD DEVELOPMENT APPENDIX NOrES Al. When interest rates change and existing debt payments can be written as the rate of change in debt obligations are at variable interest rates, the change in plus the rate of change in the interest rate. interest payments, A(rD), becomes: A frDl A AD + Ar (A4') A[rD] = ArD + rAD (Al') rD D r where A2. When r is constant, these phases are equally applicable to derive the change in the interest AD = B = [rD + I - SI; thus substituting into (Al'): payments/GDP ratio. If r changes, they still hold for the debt/GDP ratio; to be applicable to the interest A[rD] = ArD + r[rD + I- S]. (A2') pavments/GDP ratio, ADID must be replaced by The rate of change of interest payments becomes now: AD + Ar. D r A[rDl = ArL + r + I- S (A3') A3. If alternatively the concept of national savings [rDl r D (S*) is used, where S* = S - rD, the equilibrium condition (A7) can be written as S* + rD - I = X -M, This can be compared with expression (A5) earlier; which is equivalent to the well-known current account expression (A5) is a special case of (A3') and where identity S* - I = X - M - rD. Arlr = 0. In other words, the rate of change of interest