International Debt Essay

a) What is meant by the problem of ‘ international debt’? (6 marks) b) Discuss the main policies that a country can use to reduce the problem of international indebtedness (i) in the short run and (ii) in the long run (7 marks + 7 marks) a) The Balance of Payment account shows all monetary transactions between our country and the rest of the world over a period of time. It is made up of the current account (trade in goods and services), capital account (Investments, Saving, Borrowing) and the balancing item, which represents the total of all errors and omissions from the above values, which are estimates. When a country spends more than it earns i.e. it imports more than it exports (Current account), or it saves and invests more abroad than other countries save and invest in that country (Capital account), it is said that the country has a current account deficit and a capital account deficit respectively. The country facing a BOP deficit must take actions to rectify it. It usually borrows money from other countries or international financial institutions. The accumulation of debt from loaning from abroad because of a recurring BOP deficit is known as international debt. International debt developed into a problem for many developing countries, Third world countries, which are the poorer countries of the world. These are countries in Africa, Asia and South America and they represent the largest group of countries in the world both in area and population, but the lowest in income and wealth. The cause of the international debt in LDCs is their chronic balance of payments problems. They owe huge sums of money and they need to pay large sums in interest. As a result, in the world as a whole, there is a net transfer of funds from the poor countries to the rich. b) i) The Balance of Payment account shows all monetary transactions between our country and the rest of the world over a period of time. When a country spends more than it earns i.e. it imports more than it exports (Current account), or it saves and invests more abroad than other countries save and invest in that country (Capital account), it is said that the country has a current account deficit and a capital account deficit respectively. The government of a country may take actions to rectify this deficit. In the short run a country can borrow from financial institutions and other countries to correct its Balance of Payments deficit. An alternative would be to use its reserves (Gold and foreign currencies) to correct its deficit. These are temporary ways to correct the deficit and do not fight the source of the problem, they do not stop it from occurring the following year. ii) In the long run the country can take actions that would eliminate the problem that cause the BOP deficit. A country can use many different policies to correct and reverse the deficit. If the government increases taxes and, or, decreases public expenditure, there will be less money circulating in the economy and the aggregate demand would decrease. People will have less money to spend on imports, imports would decrease and the BOP deficit will be corrects. Nevertheless, a decrease in aggregate demand also affects the domestic industries. Less of their products would be demanded, they will produce less and as a result they will cause unemployment. The government can also decide to increase interest rates. This will attract inflows of Hot money (Short term investments of large sums of money that investors move from country to country in search for the best interest rates) into the country correcting the BOP deficit. The downside of this will be that the high interest rates will make borrowing more expensive and as a result consumers will borrow less for consumption and firms less for investment. Protectionism policies may be applied. These are policies to prevent trade between countries and decrease imports so that the BOP deficit is corrected. Unfortunately some protectionist policies such as import tariffs or imports quotas are usually not in the disposal of countries members of custom unions such as the European Union. A devaluation in the country’s currency will lower its value and make the country’s exports cheaper for foreign countries to buy and at the same time the imports into that country will be more expensive. As a result exports will increase and impost will decrease, thus the BOP deficit will be corrected. This is not possible for members of the ERM of the EU. In the long run a country may decide to improve the competitiveness of its Industries through supply side measures such as regional policies. Nevertheless, these policies are very time consuming and will take a lot of time to work. The country can also demand through the IMF a debt rescheduling and or new loans. This involves lowering the interest rates on existing loans, lengthening the repayment period and, or, canceling part of the debts. The IMF can provide additional loans or arrange so that financial institutions do it, with a guarantee from the IMF. In order for the IMF to do these it sets certain conditions and structural adjustment programmes that the country must follow. These conditions and programmes involve most of the policies discussed above. A further, policy would be to encourage commercial banks to finance private sector development. If governments spend too much they have a budget deficit and their income is less than their expenditure. This deficit is financed by borrowing large amounts from commercial banks and as a result not many funds are left to lend to the private sector. The IMF wants commercial banks to lend more money to the private sector, which is expected to make better use of the funds for development projects.